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Graham Summers is Chief Market Strategist for Phoenix Capital Investment Research, an independent investment strategy firm based in Washington DC with clients in 56 countries around the world.
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Daily Market Alert
  • FIVE Reasons the Market Could Crash This Fall Pt 1 1 comment
    Jul 30, 2009 1:00 AM

    With all this blather about “green shoots” and economic “recovery” and new “bull market,” I thought I’d inject a little reality into the collective financial dialogue. The following are ALL true, all valid, and all horrifying…




    1)   High Frequency Trading Programs account for 70% of market volume


    High Frequency Trading Programs (HFTP) collect a ¼ of a penny rebate for every transaction they make. They’re not interested in making a gains from a trade, just collecting the rebate.


    Let’s say an institutional investor has put in an order to buy 15,000 shares of XYZ company between $10.00 and $10.07. The institution’s buy program is designed to make this order without pushing up the stock price, so it buys the shares in chunks of 100 or so (often it also advertises to the index how many shares are left in the order).


    First it buys 100 shares at $10.00. That order clears, so the program buys another 200 shares at $10.01. That clears, so the program buys another 500 shares at $10.03. At this point an HFTP will have recognized that an institutional investor is putting in a large staggered order.


    The HFTP then begins front-running the institutional investor. So the HFTP puts in an order for 100 shares at $10.04. The broker who was selling shares to the institutional investor would obviously rather sell at a higher price (even if it’s just a penny). So broker sells his shares to the HFTP at $10.04. The HFTP then turns around and sells its shares to the institutional investor for $10.04 (which was the institution’s next price anyway).


    In this way, the trading program makes ½ a penny (one ¼ for buying from the broker and another ¼ for selling to the institution) AND makes the institutional trader pay a penny more on the shares.


    And this kind of nonsense now comprises 70% OF ALL MARKET TRANSACTIONS. Put another way, the market is now no longer moving based on REAL orders, it’s moving based on a bunch of HFTPs gaming each other and REAL orders to earn fractions of a penny.


    Currently, roughly five billion shares trade per day. Take away HFTP’s transactions (70%) and you’ve got daily volume of 1.5 billion. That’s roughly the same amount of transactions that occur during Christmas (see the HUGE drop in late December), a time when almost every institution and investor is on vacation.


    HFTPs were introduced under the auspices of providing liquidity. But the liquidity they provide isn’t REAL. It’s largely microsecond trades between computer programs, not REAL buy/sell orders from someone who has any interest in owning stocks.

    In fact, HFTPs are not REQUIRED to trade. They’re entirely “for profit” enterprises. And the profits are obscene: $21 billion spread out amongst the 100 or so firms who engage in this (Goldman Sachs is the undisputed king controlling an estimated 21% of all High Frequency Trading).


    So IF the market collapses (as it well could when the summer ends and institutional participation returns to the market in full force). HFTPs can simply stop trading, evaporating 70% of the market’s trading volume overnight. Indeed, one could very easily consider HFTPs to be the ULTIMATE market prop as you will soon see.




    2)   Even counting HFTP volume, market volume has contracted the most since 1989


    Indeed, volume hasn’t contracted like this since the summer of 1989. For those of you who aren’t history buffs, the S&P 500’s performance in 1989 offers some clues as what to expect this coming fall. In 1989, the S&P 500 staged a huge rally in March, followed by an even stronger rally in July. Throughout this time, volume dried up to a small trickle.


    What followed wasn’t pretty.


    Anytime stocks explode higher on next to know volume and crap fundamentals you run the risk of a real collapse. I am officially going on record now and stating that IF the S&P 500 hits 1,000, we will see a full-blown Crash like last year.


    3)   This Latest Market Rally is a Short-Squeeze and Nothing More


    To date, the stock market is up 48% since its March lows. This is truly incredible when you consider the underlying economic picture: normally when the market rallies 40%+ from a bear market low, the economy is already nine months into recovery mode. Indeed, assuming the market is trading based on earnings, the S&P 500 is currently discounting earnings growth of 40-50% for 2010. The odds of that happening are about one in one million.


    A closer examination of this rally reveals the degree to which “junk” has triumphed over value. Since July 10th: 


    §  The 50 smallest stocks have outperformed the largest 50 stocks by 7.5%.

    §  The 50 most shorted stocks have beaten the 50 least shorted stocks by 8.8%.


    Why is this?


    Because this rally has largely been a short squeeze.


    Consider that the short interest has plunged 72% in the last two months. Those industries that should be falling the most right now due to the world’s economic contraction (energy, materials, etc.) have seen the largest drop in short interest: Energy -90%, Materials -94%, Financials -86%.


    In simple terms, this rally was the MOTHER of all short squeezes. The fact that it occurred on next to no volume and crummy fundamentals sets the stage for a VERY ugly correction.


    Those are the first three reasons. I’ve saved the two BEST for tomorrow’s essay. Make sure you don’t miss it!


    If you’re worried about the coming collapse in stocks, I suggest a RISK FREE subscription to my confidential investment letter: Private Wealth Advisory.


    Had you subscribed to Private Wealth Advisory last year, you would have MADE, not LOST 7%. You also would have exited the market completely on September 19, 2008, a full three weeks before stocks wiped out TRILLIONS in investor wealth. And you would have outperformed every mutual fund on the planet.


    Most importantly of all, you would have understood exactly what the Fed’s moves meant for investors. There would be no confusion, no guessing games, just simple easy to understand explanations of what was going on, what it meant for your money, and how to best profit from the market volatility.


    Private Wealth Advisory costs $180 a year. That’s $0.50 a day. And I always offer a full 30-day RISK FREE trial period. Because Private Wealth Advisory is a weekly service, this means you have one month to explore the historical archives AND receive four new hot off the press issues (one a week) without risking any of your money: if you’re not 100% totally satisfied with my investment insights and gains from my picks in the first 30 days, I’ll give you every penny of your $180 back, no questions asked.


    To sign up for your RISK FREE trial, click here.

    Good Investing!


    Graham Summers

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  • odin_
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    Usually Graham Summers writes solid articles, so I'm surprised at this one.


    I've seen the same example repeated many authors. It seems to be the dead horse du jour. I still fail to understand the connection between the HFT program earning a rebate and financial collapse. If the HFT program trades inside the market (between the bid/ask), how is it evil personified? Isnt it making the market MORE efficient? If it "takes" a penny away (which I still dont understand how one forces an investor to trade at a higher price. If you dont like the price and want to risk opportunity cost trade-off: Put in a limit order and walk away. You will not pay more.), isnt it "giving" a penny more to the seller? When there is a solid, perhaps undisclosed block waiting to trade on one side, why should the other side necessarily sell (in this example) at a lower price? The HFT sniffer has done the market a favor by moving the price in the right direction.


    Secondly, invoking GS as a boogie-man seems to settle all arguments these days. The real "victims" of HFT are the "tape-readers" -- the brokers who cant keep up with the automation. Did not "good traders" try to sniff out order flow and momentum before HFTs came along? (In other words, these complaints smack of hypocricy). If we start banning technology, I am sure that the wider spreads will make GS just as profitable (likely much more as there is only a limited supply of exchange seats or market makers that GS can corner. Anyone can co-locate a server and get the same access as GS has to exchange data -- the limiting factor is that they dont have the necessary expertise to build profitable algorithms). The real losers if such luddite policies are implemented will be investors.


    Thirdly, if taking away the HFT volume brings financial armageddon, then why are going about vilifying them? I have yet to see any empirical evidence that they increase intra-day volatility (I would tend to think that increased liquidity and smoother markets with fewer gaps would reduce it). If the markets melted (and by extension volatility rose), does it not make sense that HFTs are incentivized to trade more (more opportunities to make money within the gaps) and by providing a smoother instead of gapping market, they provide a counter-cyclical impact?


    Lastly, in the good old days before ECNs, did the specialists and brokers not trade "for profit"? Did they somehow "invest" and hold even multi-hour views about what they traded? Then why do we expect HFT programs to be altruistic?


    And by HFTs I do assume that you dont mean stat-arb funds like RenTech that do take positions and do "invest" (based on correlations) even if the investing horizon might be measured in minutes.


    No comment on the rest of the post.
    30 Jul 2009, 04:02 AM Reply Like
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