Thursday, December 20, 2007

The Stock Market Conundrum

The housing market is in deep trouble, corporate profits are dropping and credit is tightening. Prices for food and energy are rising fast and the consumer is limiting discretionary spending. The chances of recession are increasing. And yet the stock market, or at least the popular indices, is stuck near record high levels stubbornly refusing to crash and burn as so many predict. What gives?

First there are the conspiracy theories: the market is being manipulated by a cabal of insiders who do not wish to see it drop for fear of economic and political consequences. Members supposedly include brokers, Treasury officials, hedge funds, etc. This is not a bad theory, as such go: the popularity of derivatives and the absence of individual investors has made equity markets much narrower and theoretically easier to influence.

The signs are there: sudden upward spikes with no news developments, just as the market appears most vulnerable to a plunge. It has been notable that this action typically takes place around 2.30-3.00 p.m., i.e. in time to artificially boost the market right before the 4.00 p.m. close. But is the market actually being heavily manipulated, or is there something else going on, potentially more dangerous?

There has always been an element of manipulation in markets. Big players routinely use dominant positions to move markets in their favor and today is no exception. The current market is characterized by a few really big houses all singing from the same "long equities" - "long risk" book and who, in addition, are all using the same black box quant programs devised by their similarly-schooled financial engineers. In other words, there is an institutionalized resemblance to the strategies and methods employed by the majority of the big participants, resulting in their moving as a herd. This bias is in turn recognized by many smaller speculators who try to anticipate and benefit from such moves, further strengthening and amplifying the moves into a self-fulfilling prophecy.

Second, program trades now account for a very large portion of the volume, as do trades that originate from hedge funds. The day-to-day importance of more traditional buy and hold investors such as mutual funds, pension and endowment funds has greatly diminished. Further, even they have allocated some portion of their funds to alternative investments, i.e. to hedge and private equity funds employing black-box tactics.

This, however, does not explain the behavior of traditional investors who still use fundamental value, top down analysis, etc. How come they are not selling? The facts suggest the answer: they are selling. Look at the sectors being hardest hit: banks, builders, retailers, automakers - they are all down very substantially from their highs, exactly following their poor fundamentals. So, the entire market is not on black-box auto-pilot mode.

This brings up another observation - the popular indices may be near all time highs, but market breadth is deteriorating. Advance-declines and new high-new lows peaked around July and are heading down; the generals with heavy influence on the indices may be marching on, but the soldiers are not. This observation is consistent with the first point, i.e. the narrowing of the market with heavy derivatives-based strategies that depend on index trading.

NYSE Advance - Decline Issues

NYSE New Highs - New Lows

NASDAQ New Highs - New Lows

What's holding up the indices? The index-heavy big caps - they are the traditional core holdings of the big, real money buy and hold institutions: Apple, GE, Microsoft, IBM, 3M, Alcoa, Exxon, Boeing, etc. The current conventional economic wisdom is that the global economy will remain strong, even if the US goes into a mild recession - and these are exactly the multinationals that will fare best. If there are conventional money managers with contrary views, it does not pay for them to act contrary to groupthink. Contrarian mistakes are punished, but conventional ones are OK.

Since real money investors are not selling core positions, black-box types and their second-tier followers can dance with derivatives to shape day-to-day index performance. The conclusion is that there is no heavy-duty, large scale government/PPT manipulation going on. But what is going on is potentially more dangerous.

What if the above conventional macroeconomic view is wrong, as is increasingly more probable? In that case the real-money institutions will start liquidating core blue chips, pressuring the indices down. No black-box can come up with the buying power needed to mop up 30.000.000 Exxon shares at once - none. In fact, if these types of orders start to pop up frequently at trading desks the black boxes themselves will go to "short equities" - "short risk" mode and push derivatives in the other direction, precipitating sharp downdrafts instead of ups. We may see a nasty replay of 1987's interaction between cash stocks and their multiple derivatives, even if the process is more drawn out than a single day or two.

Finally let's not forget the link between credit and equity markets that exists today in the form of Credit Default Swaps (CDS). Picture this: an equity trader looking over his shoulder to the CDS market and a CDS trader looking over his shoulder to the equity market, each taking cues from the other and each trying to "draw" faster. It worked very well on the way up during the virtuous cycle, so there is no reason to believe the link will be severed during a vicious cycle.


  1. What's holding up the indices? The index-heavy big caps - they are the traditional core holdings of the big, real money buy and hold institutions: GE, Microsoft, IBM, 3M, Alcoa, Exxon, Boeing, etc.

    I think what you're analysis misses here is that the super caps have underperformed the broader market (where small and mid caps have been the outperformers) over the past three and five years. Supercap P/Es are around 16, not terribly high. If you take a "mild" recession scenario of 15% decline in corporate earnings, with the same P/E, you get the S&P valued about what it was at the lows in August and November.

    The question you pose in the title to this post is one that has bothered me for some time as well. As pessimistic as I am, I can't help but think part of the solution is that there isn't a huge amount of downside risk to the large cap dominated indexes, which are really multi-nationals operating in a relatively stronger global economy. You have to bank on a dramatic US slowdown pulling the rug out from the rest of the world with a serious earnings recession to get seriously lower downside targets. I guess that's what you're banking on....

  2. Adding to your argument Hellasious, there is money flow:
    A lot of big deals closed in 4th quarter and a lot of buybacks came in too. As it seems to be an institutional dogma too be 98% invested, this helped to hold up the better part of the market.

    Now in quarter 1 of 2008 this money flow will go mostly away and you have a political/tax discussion on top - democratic president and 60 seats in Senate. So the bearish case is an easy one to make. Only timing is so difficult.
    Look today, MBIA is walking dead now and the percussions are clear to most big players; still the market is holding up relatively well. With some new year hype we might get a last hurray.....
    Or people are just slow and tomorrow morning they will understand that ACA was the first credit insurance domino and MBIA the second.....
    Hell Hellasious, I would be much richer by the end of the year if I knew the right answer.....

  3. Something that is being ignored is that GE makes or made most of its profits with its financial component. You are imagining that there is no downside risk to that? How did they loan all that money to? Oh yeah, it's insured... ha!

    Also another thing to consider, which won't show up until the financial crisis is fully under way, is that most very large corporations like MSFT have huge cash positions.. They either lend out that money or store it in an enhanced money market fund like the Florida Schools. Are you all assuming that there will be no losses to the cash accounts of these large multinationals? If so I think you should re-evaluate your analysis theory.

  4. I suppose your theory hellasious may explain the recent T-Bond rally. It seems many players are running to "safety" and/or smelling recession.

    However by the look of things a stagflation scenario is more likely than a deflation/recession one. Or maybe first a period of deflation then inflation?

  5. camabron,

    Ever read or hear about Zero Hour? When income from all sources, including new debt, does not cover the existing servicing costs? It is hard to have inflation during a debt collapse episode. The bankers can try, which I think they are doing with every method at their finger tips. Since August! And it isn't working..

    How do you fix an insolvency problem caused by to much debt and inflation with more debt and more inflation. You can't!

    Whether we have a recession lite or a bad ugly mess depends entirely upon how the financial/credit crisis unfolds. If you haven't seen the speech by Paul Krugman to the employees at google watch it.

    There are many things that Krugman only touches on slightly but the video will give you a little insight into how rare the unfolding events are and that at this point, no one knows exactly how things will turn out. That in itself is a huge red flag. No one knows how the unwinding of CDO quads and lost faith in the US financial system will unfold is not good. Fear is the next stage after denial. Fear and Speed KILL.

    There is a long held belief/theory that in a complex system with lots of noise, throw out everything other than the most probable... When you do that here, taking in to consideration that this mess was made by humans for personal aggrandizement, it is not an unreasonable assumption that these people have really messed up. Self justified greed. Wouldn’t be the first time uncontrolled greed brought wrecked some fine endeavor.

    There is lots of business/economic theory that describes cycles. From the Austrian School to the Minsky theory taken from Keynesian theory. If, in Minsky's assessment, that stability leads to instability, what is the most likely scenario.. Unless you believe in forever up and to big to fail and other glass half full theories. Then disregard all doom and gloomers and go long on margin and be happy.

  6. Yes Kokopelli that is why I was thinking first a period of deflation then a long period of stagflation as the dollar implodes and the commodity bull really takes hold.

  7. There is really a PPT, I'm employed by them to work with soverign funds to make sure the great US of A does not fall apart and suck the rest of the world into a black hole.

    BTW we control most of the black boxes, I just need to press the button on my desk if I want the DOW to close up today.

  8. To: Anonymous employed at PPT:

    Dear Santa...;)

  9. Seriously, though, about "PPT" or any such manipulation theory...

    I have said this before and I will say it again: I have seen close and personal real manipulation of an entire country's stockmarket. I know it exists and I know it can be done - at least on a smaller level.

    But when the real selling starts, NOTHING can stop a market from going down. Not even Republicans.

    The real problem with super-powerful PPT theories is that some people believe them and act accordingly, i.e. become complacent and/or figure they can make a buck following "PPT's" actions. This creates at LEAST 50% of the desired effect. Titillating rumor is so much more powerful than fact.

    For the basics on manipulation I highly recommend that people read "Reminiscences of a Stock Operator". It hasn't changed much since then.


  10. "I have seen close and personal real manipulation of an entire country's stockmarket. I know it exists and I know it can be done - at least on a smaller level."

    Please do tell us more. I'm sure you can disguise the details in a creative, amusing, and highly readable way. I think it's an interesting topic.

  11. camabron,

    Could happen that way. I have argued before for inflation. Pretty much for the same reason. Mostly due to shortages of inventories and constantly increasing populations and standards of living across BRIC countries. Even with a depression in the US, the demand isn't just going to suddenly stop.

  12. Except for the financials and real estate stocks like REITs and home builders, I am not bearish on the stock market. Why, at least you're not holding bonds. If you had bought German stocks in 1918 and held on through 1923, you would have maintained about 30% of your value. Had you bought bonds, you would have been totally wiped out.

  13. Why isn't stock market falling?

    Divide SPX by XEU and everything will be clear. Look at both last six months and last six years.

    Last six months will show that SPX/XEU topped in June and is progressively making lower lows since.

    Last six years will show that the real peak of USA was in 2000, and we have a bear flag since then.

    Fundamentally it makes sense too, because many of the going-steady multinationals were reporting higher and higher international profits, when converted in dollar.

    With the above information, can you imagine what the impact of dollar bottoming will be on the market? Dollar bottomed last month, and the market is soon going to learn a lesson.

    Lastly, here is the message to the resident commodity bull. It is over. Same goes for international bulls.

  14. "Last six years will show that the real peak of USA was in 2000, and we have a bear flag since then."

    Correction: The rally from 2002 low to now is just a bear flag in the long term bear market picture from 2000 top.

  15. I strongly recommend reading this 40-page report prepared by Sprott Asset Management.

    It is a systematic and comprehensive review of the evidence supporting the conclusion that there is a Plunge Protection Team.

    You will not find anything else as well-researched on the Internet regarding this topic.

    Here's the link:

  16. Using the DJIA/CPI, I believe we are unfolding in a contracting trangle since the high in 2000. We have completed wave "B" at the recent high and wave "C" should complete near 9110 around 12/25/2009. "D" would subsequently be 13531 around 12/21/2011 and "E" at 11012 on 10/13/2011.

    Since Wave "C" of a contracting triangle is usually steep, I predict a dramatic drop, enough to convince many that "the world is coming to an end". The US should be considerably shaken by this point.

  17. Oops. Wave "E" would be 11012 around 10/13/2012.

  18. greenie,

    I think the commodity bull still has a ways to go. The paper asset bull mkt. (financial assets such as stocks,bonds) lasted around 18 yrs. from 1982-2000. Now the shift is underway from paper assets (financial assets) into hard assets. We'll see, but I wouldn't cover my dollar shorts or sell gold just yet.

  19. Hellasious,

    You said the following:

    "What's holding up the indices?

    The index-heavy big caps - they are the traditional core holdings of the big, real money buy and hold institutions: Apple, GE, Microsoft, IBM, 3M, Alcoa, Exxon, Boeing, etc."

    So basically this would mean that institutional investors are propping up the stock market right now.

    Your chart in an earlier post of the State Street Investor Confidence Index directly contradicts this assertion.

    That index measures the allocation toward equities in institutional investor portfolios. All of the drop is accounted for by North American institutional investors (this is shown on the State Street web site).

    The index has plunged since August. It is the sharpest drop in the history of the index going back to 1999.

    The stock market has not followed suit at all. Therefore, it is not institutional investors that are propping up the stock market.

    It is something else.

    I strongly suggest that you read the report by Sprott Asset Management about the Plunge Protection Team (which I cited in an earlier comment here).

  20. Dear bernard,

    The State Street index follows overall portfolio risk and not just in equities.

    A drop can happen in a variety of ways: by moving from low-rated corporate bonds to higher-rated ones or treasurys (lowering credit risk), by reducing duration (lowering yield curve risk), by moving from higher beta stocks to lower ones (volatility risk), or by hedging market risk through derivatives.

    Risk comes in many guises...


  21. Hellasious,

    I won't argue with your definition of risk.

    However, what the State Street Investor Confidence Index measures is specifically the portfolio allocation toward stocks among institutional investors.

    It does not measure anything else but this allocation toward the stock market.

    Read the FAQ section of the State Street web site:

    This is the definition of the index IN THEIR WORDS:

    "The State Street Investor Confidence Index measures confidence directly and quantitatively by assessing the changes in investor holdings in EQUITIES"

    The index is showing that institutional investors are actually dumping stocks at the fastest rate in the history of the index (going back to 1999).

    Therefore, it is not institutional investors that are propping up the stock market.

    If you read that Sprott report on the PPT that I mentioned before you will see the following quote from George Stephanopoulos (top advisor to President Clinton) made on ABC's "Good Morning America" on Sept. 17, 2001:

    "Well, what I just want to talk about for a few minutes is the various efforts that are going on in public and behind the scenes by the Fed and other government officials to guard against a free-fall in the markets. You reported just a while ago that the Fed has lowered the overnight interest rates, will put about $80 billion into the market. In addition, the SEC, the Securities and Exchange Commission, has relaxed the rules for companies on whether or not they can buy back their stock in case they start to fall. And dozens of companies, including big companies like Intel and Cisco have announced that they would buy back their stock if necessary. Third, there will be some trading curbs in effect today. If the market drops by about 1,100 points, they will probably suspend trading for a while. And perhaps MOST IMPORTANT, there’s been – the Fed in 1989 created what is called a PLUNGE PROTECTION TEAM, which is the Federal Reserve, big major banks, representatives of the New York Stock Exchange and the other exchanges, and there – they have been meeting informally so far, and THEY HAVE KIND OF AN INFORMAL AGREEMENT AMONG MAJOR BANKS TO COME IN AND START TO BUY STOCK IF THERE APPEARS TO BE A PROBLEM."



  22. Here is the Web link (unabridged) for the FAQ part of the State Street site that shows their index definition:


    Well respected money management firm in canada disusses govt intervention in 43pg pdf......

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