From GMO’s Edward Chancellor

The Typical Characteristics of a Stock Market Mania

1. This-time-is-different mentality. Throughout history, successive market manias have been rationalized with the argument that history is no longer a reliable guide to the future. Both the “new era” of the 1920s and “new paradigm” of the 1990s were marked by a “this-time-is-different” mentality. The same mode of thinking is evident again today. U.S. profit margins are currently at peak levels and the profit share of GDP in the United States is more than two standard deviations above its long-term mean (based on data going back to the 1920s). The U.S. profits dataset is the most reliably mean-reverting financial series available, claims Andrew Smithers of Smithers & Co. Most commentary, however, assumes that U.S. profits have reached, in Irving Fisher’s immortal phrase, a “permanently high plateau.” As John Hussman of Hussman Funds comments, “Believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a unicorn.” Painful.

2. Moral hazard. Speculative bubbles tend to form when market participants believe that financial risk has been underwritten by the authorities. The “Greenspan Put” appeared in the late 1990s after it became clear that the Fed was prepared to support falling markets but wasn’t going to act against the bubble in  technology stocks. Fed policy hasn’t significantly changed since then. Monetary policy in the aftermath of the financial crisis has aimed to put a floor under asset prices, encouraging investors to take on more risk. As a consequence, U.S. household wealth – comprising largely of home equity and stocks – has rebounded to a near-record level of 472% of GDP, nearly 100% above its long-term mean. Whenever a cloud appears over Wall Street, market participants have come to expect more quantitative easing and guarantees of perpetually low interest rates. The personnel may change at the Fed, but the Greenspan Put remains in place.

3. Easy money. Great speculative bubbles have generally been accompanied by periods of low interest rates. Greenspan’s easy money policies in the last decade inflated the U.S. housing bubble, along with numerous other bubbles around the world. Bernanke’s cure for the economy in the wake of the financial crisis has been more of the same. For more than five years, U.S. real interest rates have been maintained at negative levels. An avowed aim of the Fed’s quantitative easing has been to push down long-term interest rates in order to boost both the stock market and home prices. In particular, lowering the long-term discount rate has boosted the valuation of growth stocks.

4. Overblown growth stories. Another common feature of a bubble is the overblown growth story. We witnessed this during the Dotcom bubble, ad nauseam. In the late 1990s we were told that tech stocks were experiencing “S-curve” growth (which posits very rapid growth in the near term); investors were also encouraged to value the “real options” of Internet stocks from future income streams yet to be conceived. Many of today’s high profile growth stocks – operating in fields such as social networking, electric cars, biotechnology, and, of course, the Internet – have been boosted by similar wishful thinking. Just as there were serial railway bubbles over the course of the 19th century, Internet stocks in the age of Dotcom 2.0 appear to be experiencing what my colleague James Montier has termed a “bubble echo.”

5. No valuation anchor. The most speculative markets – from the 17th century Dutch tulip mania onwards – have been marked by the absence of any valuation anchor; when there’s no income to tether the speculator’s imagination, asset prices can become unbounded. Our electronic age has even come up with a digital version of the Semper Augustus tulip. The fact that Bitcoin – the best known among the dozens of competing crypto-currencies – soared by 5,500% during the course of 2013 is testimony to the strength of the recent speculative tempo.

Needless to say, most of the recent stock market darlings – Netflix, Facebook, Tesla, and Twitter – have little or nothing in the way of profits. Internet retailer, whose margins have deteriorated in recent years yet whose stock soared nearly 60% in 2013, is the poster child for a market that is more obsessed with growth than profitability.

6. Conspicuous consumption. Asset price bubbles are associated with quick fortunes, rising inequality, and luxury spending booms. Since the spring of 2009, not only has the Fed engineered a strong rebound in the level of household wealth, but the richest part of the population has enjoyed the greatest share of the gains. Luxury spending has surged globally since the crisis.

The art market provides an excellent barometer of the speculative mood, given art prices depend entirely upon what other people are prepared to pay. A bubble in modern and contemporary art, which was evident before the financial crisis, has returned. Last November, a sculpture by Jeff Koons – Balloon Dog (Orange) – fetched $58 million at auction, a record sum for a work by a living artist. The contemporary collector apparently isn’t fazed by the fact that this dog was one of five “unique” versions or that Koons himself didn’t produce the work by his own hand but had it made in a factory. The same month, a painting by Francis Bacon sold for $142 million, the highest price ever paid for any work at auction.

7. Ponzi finance. Manic markets are often marked by a decline in credit standards. In the last decade, subprime debt inflated the U.S. real estate bubble. The financial crisis may have had many unpleasant after-effects, but it hasn’t diminished the appetite for low quality U.S. credit. In fact, we have recently witnessed the lowest yields for junk bonds in history. The quality of debt issuance has been deteriorating. Last year, nearly two out of three corporate bond issues carried a junk rating. Last year, total issuance of high yield and leveraged loans exceeded $1 trillion. More than half of the 2013 vintage leveraged loans came without the traditional covenants to protect investors. The decline in the quality of credit has attracted the attention of Jeremy Stein, one of the more market-savvy Fed governors. Stein’s boss, Janet Yellen, has also expressed concern about the manic leveraged loan market.

8. Irrational exuberance. Valuation is the truest measure of speculative mood. There are other ways to take the market’s pulse, however. Most conventional measures of market sentiment have become very elevated over the past year. The IPO market in 2013 and into the first quarter of 2014 has become particularly speculative. New IPOs in 2013 rose on average by 20% on their first day’s trading (Twitter rose 74% on the day it came to the market last November). Nearly three-quarters of the IPOs, which were launched in the six months to March, produced no profits. A good portion of these profitless IPOs, in particular those of the biotech variety, hadn’t even got around to generating anything by way of revenue. They are story stocks, pure and simple.

Other sentiment measures have been telling the same story. The trading activity of corporate insiders is a reasonably good indicator of managements’ view on the intrinsic value of their companies. Recently, the ratio of insider sales to purchases has climbed to near record levels. Equity mutual fund flows – another commonly cited sentiment indicator – have also picked up lately, while household cash balances (as a share of total assets) have declined. Margin debt as a share of GDP is close to its peak level. Market volatility has been trending downwards, while the daily correlation of stocks – another useful gauge of the market’s fear level – has also come down.

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And yes: we have all of the above right now, most of which in record amounts. So… buy, buy, buy.


Original source at: zero hedge - on a long enough timeline, the survival rate for everyone drops to zero |

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Update: within minutes of publishing this article news hit that the FBI is launching a probe into HFT. QED

For all the talk about how High Frequency Trading has rigged markets, most seem to be ignoring the two most obvious questions: why now and what happens next?

After all, Zero Hedge may have been ahead of the curve in exposing the parasitism of HFT (anyone who still doesn’t get it should read the following primer in two parts from Credit Suisse), but we were hardly alone and over the years many others joined along to expose what is clear market manipulation aided and abeted by not only the exchanges but by the regulators themselves who passed Reg NMS – the regulation that ushered in today’s fragmented and broken market – with much fanfare nearly a decade ago. And yet, it took over five years before our heretical view would become mainstream canon.

One logical explanation is the dramatic and sudden about face by none other than Goldman Sachs, which from one of the biggest proponents of quant trading strategies including algo trading, and which used to make a killing courtesy of HFT (who can possibly forget Goldman’s charges against Sergey Aleynikov’s code theft which alleged “there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways“), has in recent weeks unleashed a de facto war on HFT, first with the Gary Cohn HFT-bashing op-ed, and then with the implicit backing of the IEX pseudo dark pool exchange, whose employee just mysteriously also is the protagonist of the Michael Lewis book that has raised the issue of HFT to a fever pitch.

So does Goldman know something the rest of us don’t that it is now ready to give up on the HFT goldmine which lost money on just one day in 1238? Why of course it does. And one would imagine that judging by the dramatic turnaround exhibited by Goldman that said something is very adverse to the ongoing future profitability of the HFT industry. The amusement factor only rises by several notches when one considers that Goldman also happens to be lead underwriter on the Virtu IPO offering: one wonders what they uncovered and/or what they know about the industry that nobody else does, and just how the VRTU IPO will fare now that Goldman is so openly against HFT.

But what does all of that mean for the big picture? We hinted at it yesterday, on twitter when we had the following exchange.

Could it indeed be that the only reason why HFT – which has constantly been in the background of broken market structure culprits but never really taken such a prominent role until last night, is because the market is being primed for a crash, and just like with the May 2010 “Flash Crash” it will all be the algos’ fault?

This is precisely the angle that Rick Santelli took earlier today, during his earlier monolog asking “Why is HFT tolerated.” We show it below, but here is Rick’s punchline:

Are regulators stupid when it comes to high frequency trade? Well, i think that there was a time where they were a bit slow to the party. But i don’t think it’s stupidity or ignorance or not paying attention. So let’s wipe that off. So the question i’m asking is, why do they let it continue?


Why is it that anybody would want HFT to be unchallenged or at least not challenge it now? My reason, this is just my reason, when i look at the stock market it’s basically at historic highs. When i look at what the federal reserve is doing, it’s mostly to put stocks on all-time highs. When i look at all the debt and all the programs that don’t seem to be making a difference except for putting stocks on all-time highs, i see that you have this tower of power with regard to the stock market. And nobody wants to challenge or alter hft because it is good to go that many days without having a loss. So my guess is when the stock market eventually deals with reality and pricing, which will come at a time when there’s not a zero interest rate policy and we’re long past QE, I think they’ll address it.

Rick’s full clip:

Precisely: when reality reasserts itself – a reality which Rick accurately points out has been suspended due to 5 years and counting of Fed central-planning – HFT will be “addressed.” How? As the scapegoat of course. Because since virtually nobody really understands what HFT does, it can just as easily be flipped from innocent market bystander which “provides liquidity” to the root of all evil.

In other words: the high freaks are about to become the most convenient, and “misunderstood” scapegoat, for when the market finally does crash. Which means that those HFT-associated terms which very few recognize now, especially those on either side of the pro/anti-HFT debate who have very strong opinions but zero factual grasp of the matter, such as the following…

  • Frontrunning: needs no explanation
  • Subpennying: providing a “better” bid or offer in a fraction of penny to force the underlying order to move up or down.
  • Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
  • Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
  • Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
  • Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.

… will become part of the daily jargon as the anti-HFT wave sweeps through the land.

Why? Well to redirect anger from the real culprit for the manipulated market of course: the Federal Reserve. Because while what HFT does is or should be illegal, in performing its daily duties, it actively facilitates and assists the Fed’s underlying purpose: to boost asset prices to ever greater record highs in hopes that some of this paper wealth will eventually trickle down, contrary to five years of evidence that the wealth is merely being concentrated making the wealthiest even richer.

Amusingly some get it, such as the former chairman of Morgan Stanley Asia, Stephen Roach, who in the clip below laid it out perfectly in an interview with Bloomberg TV earlier today (he begins 1:30 into the linked clip), and explains precisely why HFT will be the next big Lehman-type fall guy, just after the next market crash happens. To wit: “flash traders are bit players compared to the biggest rigger of all which is the Fed.” Because after the next crash, which is only a matter of time, everything will be done to deflect attention from the “biggest rigger of all.”

So, dear HFT firms, enjoy your one trading day loss in 1238. Those days are about to come to a very abrupt, and unhappy, end.


Original source at: zero hedge - on a long enough timeline, the survival rate for everyone drops to zero |

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