The Pools of 1929

 In the months before the Crash of 1929 the phenomenon of “bull pools” gained great popularity. A bunch of wealthy individuals would pool their money and proceed to pump up stocks on the NYSE, often with the cooperation of the floor specialists.  The manipulation was rampant and, astonishingly, often public: many pools were announced in the press in advance in order to induce wide participation by the gullible public.  It was a kind of Ponzi scheme, where those who got in early and got out in time made money.  After the pump came the dump, of course, and the rest lost everything.  Think "meme stocks".

What is today's equivalent?  To me, at least, the constant announcement of enormous triangular AI investments between the usual suspects looks like bull pool redux.  Time will tell.

From TIME magazine, May 30, 1932

Pools. Any Wall Streeter knows, but few Senators do, how pools are run. Because the risks are great, the pool’s sponsor usually invites only his richest friends to form a syndicate. Each shares in the profits (or losses) in proportion to his subscription. Each usually makes a cash deposit for the pool manager to use as margin in his trading operations. Each is pledged to strict secrecy. With dictatorial powers, the pool manager begins accumulating stock, buying a little more each day than he sells. Stock is dumped if the price rises noticeably. When the manager has the stock he wants, publicity is shot out, bullish rumors about the company appear, the stock is “tipped,” for it is now advantageous to whisper the existence of the pool. The stock is churned over & over, bought & sold to attract attention. When outside buying begins, the pool manager drives up the price by concentrated buying. Outside enthusiasm grows, amateur traders hear a big rise is in prospect. Most pools do not play for large advances but for small profits on large blocks of stock. When the profit in sight seems satisfactory, the pool manager starts selling more than he buys, transactions increase by leaps & bounds. Canny chart readers sell too, for they readily spot the end of a pool movement by very heavy turnover with little change in price.

Sociopolitical Risks

 Following the Democratic sweep in yesterday’s elections, it is a good time to ponder socioeconomic risks facing the US and their likely impact on markets.

In a nutshell, America has never been more politically divided and economically polarized than today. Mr. Trump’s presidency is not its cause but a result of this division, a result of decades of drawing apart. On could even say that this era is reminiscent of the time before the Civil War.

I believe markets have not taken into account the risk of a sudden Black Swan appearing over America. And we do know that Mr. Trump is especially fond of “swan barbecue”…

Zero Day Options

 According to CBOE data almost 60% of all SP500 option daily volume now comes from the most extremely speculative and leveraged instrument of them all: Zero Days To Expiration options, or 0DTE for short. While they do have uses for institutions (eg index fund balancing), they are now used mostly as lottery tickets.

Apparently, these have now become very popular with retail “investors” who have piled into them in force during the last few months and are causing large distortions in volatility.

Since options market makers must hedge their intraday exposure on 0DTE, they are forced to buy (or sell) the underlying index or individual stocks, magnifying the intraday moves.

This explains the recent erratic behavior of indexes - they seem to spike or fall off a cliff within seconds.

One more layer of unregulated leverage - what could possibly go wrong…?

Addendum: after writing the above I realized I had seen this before, figuratively speaking. This is the 21st century equivalent of “bucket shops” which were hugely popular with punters in the early part of the previous century. The similarity is really uncanny.. see Reminiscences Of A Stock Operator.

Margin Debt Soars

The amount of margin debt in the US has soared to a new high of $1.13 trillion in September (data: FINRA). Some will say that we should look at it as a percentage of total market cap, and I agree. 

However, I have a different point to make. Look at how fast margin debt has increased in just a few months: up 30% since the beginning of the year and 50% in the last 12 months.  This is an indication of froth created mostly by retail speculators who are piling in to make a quick buck.

Does not look good to me…

Leverage and Risk Transmission Mechanisms

 The Great Debt Crisis of 2008-10 was the result of inordinate leverage created by arcane derivative instruments like debt tranches, Collateralized Mortgage Obligations (CMO), Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS). Some of them were even further leveraged, eg CDO squared and cubed.  The degree of interconnection was extraordinary and once one or two dominoes fell, the result was a disaster.

Fast forward to today. Are there similar leverage and risk transmission mechanisms in place? Yes, there are.

1. Exchange Traded Funds (ETFs): once a tiny portion of markets, they are now very popular with retail investors and speculators alike. The biggest ETFs are index trackers, and they MUST buy or sell to follow the underlying index. There are literally thousands of them, with assets estimated at $11 trillion for the US market alone - that’s a massive 20% of total market cap. To make it worse, a mere 10 companies account for 40% of the entire S&P 500 index, which itself is capitalization weighted. Therefore, a very large percentage of stock owners who MUST follow the index are currently sitting atop an extremely narrow market. The operational market leverage risk is unprecedented. By the way, many of the ETFs are 2x and 3x trackers, using futures and options, so there is even more leverage involved.

2. Algorithmic trading. By definition, algorithmic trading is mechanistic. Create a “formula” and follow it, again and again. A massive 70-80% of all daily trading volume in US equities is now algo based and, more worrisome, some 40-45% of this is retail. Algo is, therefore, another layer of “hands-off, brains out” market participation. Like all algorithmic models, algo trading is optimized to perform well under current conditions and is based on current assumptions. This is strongly reminiscent of the debt “tranching” model which was based on flawed assumptions and precipitated the Great Debt Crisis.  

Put everything together: ETFs, algo and an extremely narrow market. The leverage risk transmission mechanism is, in my opinion, very dangerous and prone to a China Syndrome incident. Can anyone throw a switch to prevent it? Can it be done fast enough to stop a meltdown?

Final word: a market exhibiting the above characteristics can be very easily manipulated.