Panic,
Re-liquification,
Market Manipulation and Moral Hazards
John Riley - Chief Strategist
08/21/07
Panic
Selling
Markets are prone to panics. Think of it as a run on the bank, but
instead of everybody standing in line to get their money, they sell
their stocks, bonds and mutual funds.
The markets
started showing signs of a panic recently. But the question is who
was panicking?
The key reason
given for the recent declines has been sub-prime mortgages. No argument
there. It is a big problem.
But who invests
in sub-prime mortgages? Not the vast majority of mutual funds. Not
commodity companies. Not the average stock on the NYSE. Yet these
were all victims of the recent declines, having losses that rolled
many charts over into bearish patterns.
Re-Liquification
The markets had all of the earmarks of a rush for cash. Everything
was being sold, stocks bonds and commodities. It wasn’t a
re-allocation, it was an exit from the game. If you remember the
article we wrote in July (Money, Money…) we talked about the
lack of liquidity in the system. It would seem that we were not
the only ones to have noticed just how dry the system had run. The
Sub-Prime mortgage mess was just the catalyst.
Market
Manipulation
Program trading has gotten out of control. According to the NYSE,
the most recent numbers show that recently, program trading accounted
for over 70% of the market’s volume, with one week, program
trading was 98%. This is one of the reasons we care very little
about the day to day moves of the market since they can be manipulated.
What is Program Trading?
It is large trades (tens of millions of dollars) done to
take advantage of mis-pricings between markets. Program trading
has been around for a long time, but the control they have
over the markets has never been this great.
About a year ago, the NYSE re-calculated the way they measured
program trading. This was done right after a week when program
trading accounted for over 90% of the market’s volume.
The formula for the new measurement methodology is complicated
I’m sure. The reason I say that is because the NYSE
was kind enough to have the old and new methodology on the
same report and it appears all they did was cut the old numbers
in half. This substantially lowers the reported impact that
program trading has on the market.
In the chart below, I have redrawn the chart based on the
old methodology. For the past few months program trading has
been well above 70% of the average volume with one week coming
in at 98%.
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The charts below
show some of the recent market activity. It looks like they are
waiting to the end of the day to set off the fireworks. Moves of
200 and 300 points in the last hour or two have become commonplace.
A couple of days it looks like they programmers didn’t get
the message out to everybody about what direction we were going
that day as the market falls precipitously and they rallies a few
hundred points.
Here’s
a chart that really shows the obvious hand of market manipulation.
A few days before the Fed lowered short term rates, the 30 day T-Bill
yield dropped. The chart shows that the rate had been flattish,
and then all of a sudden, rates dropped precipitously right before
the Fed lowered rates. Hmmm… Seems suspicious to me. Who did
it? I will let the conspiracy theorists wrestle with that.
As crazy as
this type of trading is, at least an investor can rely on the long
term trends and fundamentals. Or at least we could.
Moral
Hazard
The Fed has decided that it wants to play market manipulator also
and when they play, they can mess up intermediate trends and can
make fundamentals irrelevant.
The Fed’s
interest rate cut, which was a panic move by the Fed, was blatant
market manipulation. It was done after a couple of weeks of much
more subtle manipulation failed to produce the desired results.
The Fed, along with other Central Banks around the Globe, had pumped
hundreds of billions of dollars into the system in an attempt to
calm markets. But the markets absorbed the cash and wanted more.
So here’s
the problem. If you have a brother-in-law that asks you to loan
him some money so he can pay off his credit cards, do you do it?
Let’s say you do it and then a month later you find out he
is taking a vacation to the tropics, but still hasn’t paid
you back yet. Then a few months after that, he comes to you again
for more money because he’s up to his neck in credit card
debt again. Do you help him out?
Now let’s
look at what the Fed is doing. Mortgage lenders helped create the
problem they are facing today. They gave loans to almost anybody.
I heard stories that pets got mortgages! People without jobs got
mortgages. Now, those questionable loans are biting the lenders.
Many of the people can’t afford to pay on them and because
the real estate market has fallen on its face, they mortgage companies
are having a hard time finding new qualified people to lend to.
But is it the
Fed’s job to bail these companies out? Is it the Fed’s
duty to make sure that mortgage lending companies don’t go
out of business? Didn’t the companies make the bad loans?
Is it the Fed’s job to protect companies from themselves?
And what happens
if the Fed does bail these companies out? What keeps them from doing
what your brother-in-law did? .
The Fed has
created a Moral Hazard that now financial companies can expect the
Fed to come bail them out when they get themselves into trouble.
It only makes sense that if they bail out mortgage companies, they
would certainly bail out banks. And don’t forget brokerages,
they raised lots of money for mortgage companies.
And the Fed
would also certainly have to help out the home builders. Without
them, what good is it helping the mortgage companies. And then there
are the building supply companies - can’t have homes without
plumbing and electrical supplies and the lumber industry will absolutely
need some of the Fed’s limitless help.
And what about
Detroit? They are being pummeled by the advantage those foreign
car makers have because of the Dollar (It has nothing to do with
foreign cars being better cars.) And since the Dollar is the Fed’s
responsibility, shouldn’t the Big Autos get billions in aid
from the Fed?
Where does it
stop? Is the Fed going to take the “cycle” out of “economic
cycle?”
Conclusion
We don’t believe they will or can, even if they wanted to.
We immediately saw the downside to the Fed’s interest rate
cut, the Dollar fell and long term interest rates went up. Yes,
rates went up when the Fed lowered rates. The Fed only controls
short term rates. The market controls long term rates and they didn’t
like what the Fed did.
It has long
been anticipated that if the Fed lowered rates the Dollar would
drop. A declining Dollar is very bad for long term interest rates
and inflation. So while the Fed thinks they are helping short term,
they are doing exactly the wrong thing to help the economy long
term. Higher inflation means higher oil, gold and other commodity
prices and higher long term rates will help put the last nail in
the housing market, the economy and the stock & bond markets.
And the economic
cycle will go on. Delayed, but go on.
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