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Good morning. Yesterday morning's sudden dive in the stock market was a great example of HFT (high frequency trading) in action. I was on a conference call at the time yammering on about our approach to stock selection and our active risk management system. In the midst of explaining the importance of having a risk management system that could adapt to changing environments, I glanced up at my screens. To my surprise the S&P 500 was in the process of plunging from 1454 to 1443. Although I was on a call, I assumed that someone had said something in Europe - again.

However, when the call ended I immediately jumped into my news feeds and found ... wait for it ... nothing. Nope, there was no new development on Greece, Spain's PM had been remarkably quiet, Merkel wasn't talking, there wasn't a peep out of Schauble, the IMF hadn't lowered any more forecasts, and, there wasn't even the daily downgrade from one of the so-called rating agencies. Nothing, nada, zilch.

Oh, except for the NASDAQ breaking its 50-day moving average that is. No, I'm not kidding. Apparently the fact that Intel (INTC) and Apple (AAPL) were falling was enough to push the NASDAQ through one of those uber-important moving averages, which, in turn, had caused the algo's to go into sky-is-falling mode (and yes, my sarcasm is indeed intended). Before you could look up the definition of latency arbitrage, the computers were all chasing the latest trend to the downside, the S&P had shed nearly 1%, the NASDAQ was in a free-fall, and suddenly everybody was talking about bear markets.

To which I'd like to respond with, seriously? If I hadn't seen it with my own eyes, I'd be hitting the b.s. buzzer on such an explanation. But believe it or not folks, this is what the U.S. stock market now represents. A bunch of high speed computers sending trades out every few milliseconds. Trades that no one is policing. And trades that the so-called policing agencies may not even completely understand yet.

According to a report I saw out of NANEX yesterday, 99.9% of all quotes on the exchanges and 70% of all trades completed are done by HFT. This means that there is literally nobody on the other end of the trade you are placing. Well, except for a computer looking to front run your order so they can scalp a fraction of a penny.

Here's how the game is played. If you enter a bid to buy 500 shares of Google (GOOG), the computers "see" your order because unlike the big boys, we normal investors are forced to trade on the traditional or "lit" exchanges (as opposed to "dark pools" where the big funds trade in order to hide their bid and offer prices). This means that our orders are visible to anyone and everyone. From there, the computers then race each other to take get in front of your order to buy GOOG. Some HFT algorithms "jam" the exchange with thousands of orders, designed solely to slow down the exchange's computers while others send out false quotes that try to "trick" the market into moving in one direction or the other. These practices allow the HFT gang to jump in front of your order, pick it up and then sell it back to you or somebody else on another exchange at a different price for a small, but very quick profit.

If you are like me, you may be wondering why this is legal. Sure seems like either front-running or market manipulation at its finest. And the last time I checked, both practices were illegal. But legality seems to be in the eyes of the beholder these days. You see, the NYSE is now a for-profit organization and is more than willing to provide your bid price to the HFT crowd milliseconds ahead of when it "officially" hits the tape - for a not-so small fee of course. In other words, for the right price the exchanges will sell the information about somebody's order BEFORE it hits the tape. From my perch, such practices are amazing, unethical, and disgusting. But unfortunately this is a true story.

In their defense, the exchanges and HFT firms all sing the same song. "We provide much needed liquidity to the market," they will say with their heads and chests held high. Except they really don't. The reference to "liquidity" by the HFT firms is intended to make us think that the computers have replaced the old specialist system - where a market maker was required to stand ready to buy and/or sell 100 shares of the stock they covered at all times. Sure, there were ways around this system, but for the most part it worked pretty well. The HFT gang would have you believe that they provide this service. Except that, as I mentioned, they don't. They dodge and weave around orders in order to get what they want. If prices aren't going the way the computers want, they simply walk away. No, these firms absolutely, positively do NOT provide liquidity. But they DO produce lots of volume for the exchanges to profit from.

A big part of the problem with HFT is no one is monitoring the practice. We all know about the Flash Crash and Knight's rogue program that cost the firm $40 million in less than an hour. And you've probably heard about the recent spike in Kraft that hurt investors. But did you know that there was talk of "haywire" HFT trades just yesterday in a handful of stocks as well as the financial ETF (XLF)? The point is that the computers have the ability to move the market at the speed of light and there is nobody holding them accountable (well, not to any meaningful degree) at this time.

Sure there are proposals to "tax" HFT traders that never actually complete a trade. (According to Nanex, one such HFT trader placed orders in 25-millisecond bursts involving about 500 stocks last week - and the algorithm never executed a single trade. But this trade did account for 4% of the quote traffic over a period of days - all without ever executing a single order!) And there is lots of talk about what to do. But when the opening bell rings this morning, it is scary to realize that the computers, which control the vast majority of trading, are on their own.

Turning to this morning ... Despite yet another warning from the IMF, some concern about global growth from AA, and another batch of red numbers in Europe, the futures in the U.S. are currently pointing to a flat-to-modestly-higher open.

On the Economic front ... We'll get Wholesale Inventories this morning and then the Fed's Beige Book report this afternoon.
Thought for the day ... Try not to let success go to your head or defeat into your heart ...
Pre-Game Indicators
Here are the Pre-Market indicators we review each morning before the opening bell ...
  • Major Foreign Markets:
    • Shanghai: +0.23%
    • Hong Kong: -0.08%
    • Japan: -1.98%
    • France: -0.26%
    • Germany: -0.21%
    • Italy: -0.35%
    • Spain: -0.69%
    • London: -0.40%
  • Crude Oil Futures: -$0.01 to $92.38
  • Gold: +$2.70 to $1767.70
  • Dollar: lower against the yen, euro, and pound
  • 10-Year Bond Yield: Currently trading at 1.738%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +0.57
    • Dow Jones Industrial Average: -6
    • NASDAQ Composite: +0.08
Positions in stocks mentioned: AAPL
Source: Daily State Of The Markets: Let's Talk About HFT