To My Clients, Friends & Observers:
It’s Hard Not To Be Cynical
Economic growth in U.S. - in fact everywhere ex China - is anemic. The U.S. Energy Information Administration (EIA) reported that U.S. oil stockpiles rose another 1.7 million barrels in April, to record levels of 399.4 million. Subsidiary oil products inventories have been increasing also, suggesting that prices should start to slide. But they don’t. There is more oil above ground than ever before in history. Yet oil company stocks are near their 52 week highs.
Whenever oil prices drop to a particular level, they price alternative energy sources out of the market. As it is, solar, wind, and electric car technologies require significant government subsidies to remain economically viable.
There has been no significant anti-trust action against the oil industry in decades despite considerable consolidation, e.g., Marathon Oil merger with Ashland in 1998, Exxon Mobil merger in 1999, ARCO to BP in 2000, Shell with some Texaco assets in 2001, Chevron with the rest of Texaco in 2001, and Conoco with Philips in 2002. Regardless, a bipartisan monograph written by Clinton and Bush appointees Richard Parker and Timothy Muris in 2007, with the “financial support of the U.S. Chamber of Commerce,” found the oil industry “intensely competitive, innovative, and subject to more scrutiny and tougher antitrust standards than any other industry.” (Cha-ching!) Their report acknowledged that the industry had not built a new gasoline refinery since 1977 because of capital intensity and environmental regulatory constraints, making do instead with upgrades and improvements to existing facilities. (Since then, two small new refineries have been constructed in South Dakota, and capacity has doubled in two larger refineries in 2009 and 2012 in Texas and Louisiana.) The purpose of the paper was to “provide decision makers with the tools to make wise decisions that will benefit consumers and lower prices at the pump.” (Cha-ching!) It appears they failed.
Considering the aggressive subsidy of alternative energy production, reticence regarding any OPEC censure, and the web of EPA regulations on new refinery construction, it is inconceivable that the oil oligopoly (monopoly of a few) could misinterpret such an implicit message: raise prices at will. Laws of supply and demand are suspended. Gasoline prices are artificially high. By the way, state and federal taxes combined average about 15% of the price at the pump.
In the 1990’s low oil prices combined with the peace dividend fueled the robust economy. For most of the Clinton years gasoline retailed at $1.10 (in 2010 inflation adjusted dollars). In nominal prices, gas got as low as 60 cents a gallon. That ended quickly into the Bush term. During the Clinton years there was a lot of creative disinformation, e.g. the statistical amount of crude in storage was so mercurial as to be anybody’s guess. There were innumerable tankers drifting at sea, loaded with oil, with no place to unload. That situation exists today but premium gasoline and diesel fuel still retails at $4 a gallon, constraining other consumer spending.
Late in the day on May 7, 2010 I attended a Westfield High School tennis match. My wonderful son was team captain, and he won another fine match. Between sets another father approached me and asked if I was in the investment business. He had a stock trading account with a discount broker. “Can you explain to me what happened yesterday?” He was agitated.
“Yesterday” had been May 6, when at 2:45 P.M. a “flash crash” occurred. The stock market dropped 600 points, over 9%, in a few minutes and then recovered entirely in a few minutes more. The man tended his portfolio carefully and dutifully had in place “stop-loss” orders on all his stocks, approximately 10% below their market prices (as recommended by so many free-advice gurus in print, TV and internet). When he retrieved his emails that evening, he was shocked to see a large number of sell trades in his account. As a result of the flash crash he had been stopped out of 80% of his stocks, at 10% to 30% losses. A phantom had stolen 15% of his portfolio.
(A sell stop order at $20 directs the market maker to sell the stock at the next market price after any sale at $20. A stop limit order at $20 would trigger the order but limit the price to no less than $20 - but only if there is a market at $20.)
It was too late to advise caution in the use of stop orders. To whom or what did he have recourse? It was an expensive and galling lesson. The only explanation I could offer was that “technical trading programs” had run amok. In the days that followed “computer glitches” were cited. Of course there are no such things as “glitches.” There were reasons for the event and doubtless they related to trading programs. In the days and weeks that followed the term “High Frequency Trading” (HFT) became commonplace. In the years since, high frequency traders have become apparent if nearly inscrutable, at least until Michael Lewis’s most recent book, Flash Boys, which I found impossible to put down.
“Front running” refers to a market maker using information given to him/her in the course of trading to his/her own advantage. For example, on receiving a buy order for 100,000 shares of a stock, the market maker buys 10,000 for his own account before executing the 100,000 share buy order which drives the price up into which he sells the 10,000 just bought. Or he might buy a call option on the stock in anticipation of the price increase. He/she could profit on sell orders the same way, selling or shorting or buying put options in anticipation of falling prices. Front running is unethical and illegal and is now commonplace because of high frequency trading in “dark pools.”
Front running is a serious violation and was easily detected on the fairly transparent, open outcry trading of the New York Stock Exchange. But the old NYSE has been replaced by dozens of electronic trading exchanges that are closed, opaque systems that organize buys and sells according to algorithms written by programmers owned by the market makers. Orders are recorded on the exchanges by the second, but they are executed by the microsecond (one millionth of a second). The ability of machines to trade in microseconds has enabled front running to an extent never contemplated by regulators. HFT is being studied by regulators.
Here is a hypothetical high frequency trade. A sell order at $20 is received by the HFT; in microseconds the market moves to $19.95 creating an arbitrage opportunity for the HFT market makers’ algorithm which it executes in microseconds. Another sell order at $19.95 triggers an automatic market adjustment to $19.90, and so on and so on. Or traders can enter multiple bids, pushing the price up, and then withdraw their bids and execute a sale at the higher price.
Defenders of the practice say that HFT has created greater efficiencies and narrower spreads for investors. They say the amounts collected by these trading arbitrages are miniscule and a legitimate cost of trading. This is bogus. The amounts collected are in the billions. The flash crash illustrated the systemic danger of HFT.
Lewis writes that, during the flash crash, “Shares of Proctor & Gamble…traded as low as a penny and as high as $100,000. Twenty thousand different trades happened at stock prices more than 60% removed from the prices of those stocks just moments before.” This must be the clearest warning of the dangers of unchecked HFT front running. While there is no hard evidence and no data from dark pools, it is easy to surmise that the reason PG dropped to a penny was because the algorithm drove the ask price lower, each drop in the ask triggering another drop, a cascade of falling prices, in microseconds. When there’s no bid, there’s no bottom. The price of a stock will fall until a bid to buy is made. A penny is the last stop before zero and the stock went to a penny before a bid came in and when it did, the algorithm triggered the same sequence on the bid side, driving the price to $100,000. PG actually opened at $61.91 that day and closed at $60.75. Lowest execution was $39.37; highest was $62.67.
Without giving away the story, Flash Boys is about a seemingly incongruous group of Wall Street workers who figured out HFT and electronic front running. They established a new exchange, the IEX, to allow its customers fair trading. Once again, Michael Lewis has taken another esoteric financial subject and turned it into a fascinating human story. The SEC has been studying HFT and dark pools and some significant regulatory changes are expected.
Now consider the effects of HFT on ETF’s
Exchange Traded Funds (ETF’s) were slaughtered during the flash crash. The herding of complacent investors into passive “low cost” ETF’s is exasperating to me. According to Jonathan Laing in the August 4th Barron’s (Can ETFs Be Derailed?), “Some 20% of U.S. equity ETF’s lost more than 50% of their value before the snapback, according to Morningstar. Nearly 70% of all trades that were cancelled that baleful day involved exchange-traded funds.
“The APs and other market makers couldn’t absorb the selling tsunami because it left them with nowhere to lay off the risk. Too…(they) correctly assumed that gobs of trades eventually would be cancelled, leaving them potentially exposed on at least one leg of any trade.” This is to say that they did not do what they are supposed to be obligated to do - take the other side of a trade when there is no other, answer the bid or ask, be the market maker of last resort.
APs are “authorized participants.” They are the major investment banks and brokerage houses who create or redeem shares of ETF’s as investors buy or sell. The APs make their money by exchanging units they create with the underlying assets, profiting on the arbitrage between the prices of the ETF and the underlying asset. This is what is supposed to keep the prices closely aligned - until it doesn’t, as in the flash crash.
Many APs are also HFT’s. It doesn’t require much imagination to see the potential for high frequency ETF trades provoking a volatile sell-off in underlying assets, a liquidity crisis for APs, a market freeze by market makers, and/or failed executions or worse for ETF shareholders. The permutations of a cascade of events leading to catastrophe are considerable. Wall Street is dedicated to getting the market up, but who or what will stop runaway trains?
We are presently managing the portfolios of a family that was recently introduced to us by an existing client. After establishing a rapport our new friends brought in their brokerage statements from their former adviser. Their advisor was well lettered, a JD (though he does not practice law) and a CPA (though inspection revealed that his CPA had been suspended). He had hosted his own radio show for years about investments and taxes. Our new clients had started working with him in the spring of 2009. As of spring 2014, their portfolio values were actually worth less than when they started. It seemed almost impossible. The S&P 500 Index low was 666 in March 2009. It was approximately 1850 in March 2014, an increase of over 170%. How could one possibly lose money during that period?
I analyzed their portfolios. They were a mostly a polyglot of “low cost” ETF’s, REIT’s, and no-load mutual funds. What a huge opportunity cost.
August is the quietest month; September the worst; and October the 2nd worst. Barring global catastrophe, November and December look good for the S&P north of 2000. Second quarter corporate earnings were generally robust.
Revisiting the 100th anniversary of the start of World War I, it is chilling that no one foresaw events spiraling into such a conflagration. Sixteen million people died. Yeats’ epitaph read: “Cast a cold eye…” I’m looking out for you. Best regards.
Dennis M. O’Connor