Buffaloed by Boredom and Bernanke
It would figure that the week that I was out of the office we’d have our most popular newsletter of the year. My interview with a real life HFT last week got linked in a few high profile places and traffic was way higher than it usually is. I apologize if some of you had trouble accessing the website or if it wasn’t loading properly. Everything is back to normal now so you can go back and read it in case you missed it.
The real surprise, I suppose, is that I didn’t get any hate mail on this one!
I’ve had people ask, and my personal views on high frequency trading are probably somewhere in between someone like Rishi Narang and someone like Joe Saluzzi, who is an intelligent and eloquent guy, and whose efforts since the Flash Crash can only be described as a crusade. I try to take as unemotional a view as possible on the topic.
The biggest problem with HFT is that most people simply don’t understand it and that a few bad actors and high-profile market events have shaped public perception of the activity. We’re scared of what we don’t understand. Regardless of where it happens, that kind of fear creates myriad problems.
On the one hand, there’s no doubt that because of high frequency trading we have lower spreads and lower transaction costs. It’s been a long, steady journey from the world of specialist-handled sixteenth-point spreads to markets made by computers with penny-point spreads. Somewhere along the line the social benefits of that plateaued, but I really do believe that framing HFT in terms of social benefit is the wrong way to go about it. There’s absolutely no reason why they should or we should expect them to provide any sort of social benefit. Their purpose in the marketplace is to make a buck, not help the rest of us out, especially the ones who aren’t contractually required to make a market.
The HFT kicker lies with the negative externalities. There’s a legitimate track record of some of these guys creating and being connected to some major market mayhem. Whether they’re any more or less disruptive a force than other large market participants or rogue traders is an important question to debate.
The rest of us have a perceptual problem when it comes to liquidity and what it means today. We see markets today that appear tremendously liquid, and for the most part, they are. But markets have a lengthy history of events where, for reasons known and unknown, liquidity vanishes. When liquidity vanishes, prices fall, and fall quickly. In that flash crash of 1962, the Dow dropped nearly 6% on the day and some stocks fell as much as 10% in 20 minutes. The specialists in the market pulled the liquidity plug in the same manner that HFTs have in today’s sharp market dislocations. No student of history should take liquidity for granted, at least not in the form that exists from day to day or minute to minute. (Reason #1,323 why I’m a long-term investor.)
Finally, I’m discomforted by the philosophical strategy that opponents have used to attack HFT. Most of the criticism seems to center on social externalities. That they “prey” on investors and because they move in and out so quickly they make the markets a more dangerous place to trade. This is a slippery slope. When you really get down to it, the only difference between a high frequency trader and a long-term investor is the time frame over which they’re investing. Both are trading based on what they perceive the value to be in the future. This is how anyone generates alpha.
So how fast is too fast? The IRS gives you a pretty nice incentive to hold investments for at least a year. Is anything less than a year too fast? What about an intra-day trade? Is it OK for a trade to last 30 seconds? One second? A nanosecond? Where do we draw the line? At what specific point in history did we collectively decide that high frequency trading was a bad thing and how fast were they trading at that point?
I don’t have the answers. High frequency is among the most gray subjects in the industry today. One thing is clear, however, and it’s that the practice isn’t going away. The SEC, which used to be way behind the curve, is finally catching up. We understand this stuff better than we used to, and know how to do a better job rooting out the sketchy and semi-fraudulent HFT behaviors. Don’t get me wrong, some HFT behavior is undeniably problematic.
Look, nobody really cares who’s doing what in the market as long as the markets don’t go haywire. We’re never going to fully understand the unique constellation of events that cause liquidity to vanish, nor will we ever be able to properly anticipate it. We didn’t understand it in 1929, 1962, 1987, or 2010. We won’t truly understand the flash crash of 2035 either. It’ll catch every last one of us off guard, and we’ll point our fingers at… I dunno… something.
This ought to cause you much greater existential unease than anything else you’ve ever read about HFT.
Buffaloed by Boredom
I’ve been getting caught up on the markets this week. So far, September has been a relatively quiet month. That’s a good thing! Historically, September is one of the worst months both in terms of news and performance. I’m glad that the biggest scary story that the world can drum up right now is who will replace Summers as front runner from the Fed.
This is the kind of year that’s been great to be an investor, but only if you’ve managed to stay away from the “noise” and not out-think yourself. I read elsewhere that CNBC ratings are at major lows.
It’s unlikely that CNBC will ever sustain the type of ratings they had during the late days of the tech boom and the early days of its collapse. That was a very unique window in history. At some point in the future, the market will crash again. Probably not the way it did in 2008 — that was a once-in-a-generation event — but it will fall sharply and people who don’t normally watch CNBC will turn it on again to see what the heck is going on.
I actually do think there’s market meaning buried in this chart. But first you need to incorporate a few secular factors into it. Ratings rose steadily in the 90’s because CNBC, then a young channel, was finding its market. It obviously overshot with the hoopla and panic of the dot-com mania, and by 2003 had settled into what should probably be expected as a normal viewership. As things got better and stronger, ratings fell and stabilized. But then real estate started to crack and people started paying attention again. Viewers really turned on when the stock market started melting down. Since then, as the economy has stabilized, viewership has declined.
CNBC has more competition now, too. I guess a few people are watching Fox Business, and with around 10% of CNBC’s viewership, FBN can probably eat a bit more into CNBC’s share of the market. Bloomberg’s ratings are a closely guarded secret and more difficult to measure since the live broadcast is available for free online and in their excellent Bloomberg TV+ app (which is what the future of television is going to look like, in case you were curious).
I’m almost certainly biased, but anecdotally, Bloomberg seems to have also stolen a bit of CNBC’s former share, especially within the financial industry and within high income & high education households. I happen to think that CNBC puts forth a really great product that’s really entertaining. But I don’t know a single person who truly knows their financial shizz that doesn’t watch Bloomberg over CNBC. And don’t laugh, but Bloomberg Radio is where it’s really at. I know this because I hear people like Jim O’Neill and Bill Gross talk about how they listen to Bloomberg Radio on their drive in to work and how frequently they’ll add to comments from guests in the preceding segments.
In any case: financial media ratings do tend to bottom during periods of complacency and spike during periods of chaos. That’s exactly the type of hypothesis any reasonable individual would come up with, and it’s exactly the type of pattern we see in the data.
Nobody’s watching these networks right now, so if someone tries to sell you this notion that the world is falling apart and it’s all going to hell in a handbasket, don’t buy into it. That isn’t happening right now.
Ratings are almost by definition a lagging indicator, so for them to be of any utility, you’ll have to use them as a confirmation signal. If you buy into the idea that it’s bad to make long-term investments during environments of complacency, using CNBC ratings as a proxy for how closely people are paying attention, this may be one of those times.
Buffaloed by Bernanke
And along those lines of false panic, check out yesterday’s action.
Now, don’t get me wrong, that was some pretty real movement in the Treasury market. Balanced fund managers and asset allocators like myself threw our hands up in the air and danced a little jig. It was a pretty awesome day for the kinds of portfolios I run in Alpine Advisor (to the extent that one day’s action swings my emotions one way or the other).
I still marvel with fascination at the continuation of this perverse “Fed has economic worries –> market rallies” phenomenon. It’s a logic puzzle with no solution, only increasingly acute phases of insanity.
I get why bond prices would go up if Bernanke & Co. say they’re going to keep buying because they economy’s weak, but why should equities rally? I understand that stocks will do any old thing on any old day for any old reason and that most of this stuff is one big mystery anyway. But don’t stocks usually tend to drop on signs of economic weakness? Who knows. What do I know? What does the Fed know?
Somewhere out there I’m sure someone’s making the argument that, well, if interest rates are going to drop, then maybe stocks are more attractive based on their earnings yield. I guess that’s a somewhat legitimate line of reasoning. But what about everybody that says Fed Model thinking is bogus? And on the other side of that same coin are analysts who argue that QE doesn’t affect stock prices. What do they say about days like yesterday?
Randomness, I guess.
I honestly don’t know.
I suppose it’s an opportunity for people with a long-term perspective to take advantage of short-term action that makes no sense whatsoever. I know that over long windows of time, fundamentals are pretty much the only things that matter (GDP, inflation, earnings growth, dividends, etc.). Most of you already know how I feel about the long-term fundamentals.
There are some lessons here, too. Just a few short weeks ago, many of us were sweating and regretting that we didn’t sell some of those stocks and bonds. Now we’ve all got a second chance. I wouldn’t even think of shorting the market here and would much rather just ride along with all the momentum. But depending on my horizon, I’d at least think about taking some of what I had on the table off.
What we’ve seen in 2013 in the bond market is the future. I know we call these bond programs Q-Infinity, but they will stop at some point. When they do, it’ll lead to higher rates. Higher rates mean bonds go down. It means you lose money on your risk-free U.S. Treasuries.
This is the future.
Please tell me that we’ve all learned this lesson, right?
As for those little twinges of bond bullishness I had a few weeks ago when the 10yr was pushing 3%? Completely extinguished. It was fun while it lasted! Check back when the world is freaked out again about tapering and ready to write bonds off altogether. Any Bond Vampires who slipped the crypt a bit early are now scurrying back to their coffins after a quick, cheap feeding. They’re hungry for more, though, and their time to drink deeper will have to wait until the blood is running a little easier in the streets of Bondville.
In the meantime, I’m back to being more attracted to stocks than bonds on a relative basis, though in an absolute sense, both represent rather unappealing long-term propositions. And with real estate no longer penciling out with the prospective yields it had a year or two ago and the managed futures space stuck in the performance doldrums, you can imagine what kind of mental meltdown a balanced strategist like me is having right now.
The fact is that there just aren’t that many asset classes out there with the kinds of valuations that get me excited. And there aren’t a lot of assets that investors hate right now. For guys who like resilient, cheap assets that the rest of the world hates, the pickins are pretty darn slim. I guess we just go back to hanging out until the market gives us opportunity. Don’t worry. It’ll happen. It always does.
Go See Some Buffaloes
In retrospect, this wound up being a great time to take a vacation. I spent last week in Yellowstone National Park and fly fishing in Southern Montana. If you’re an investor like me, you should probably take a vacation now as well! Sometimes, the best trades are the ones we don’t make. Vacations are great for helping avoid making stupid trades, and they’re a great way to regain perspective on both the markets and life.
Don’t worry, the markets will all still be here when you get back. I guarantee you that surprisingly little will have changed.
For those of you who enjoy this sort of thing, here are a few pictures I took while on my trip. Now you can see why I have buffaloes on the brain. (Seriously, don’t click on that link unless you want your head to explode.)
Yellowstone National Park should be a bucket list destination for every last one of you, and doubly so if you have an interest in photography.
See, doesn’t that look like more fun than fretting about tapers?