We wrote a couple of months ago about the challenges the policymakers face with the economy, financial system, and securities markets (oh what a tangled web we weave when we chase money and power). As this web is woven, essentially by the players on Wall Street and in Washington, the decision making process for investors becomes more complex. Just thirty years ago the investment world was relatively primitive, dominated by stocks and bonds. Now the landscape contains a myriad of investment opportunities, mostly in some form of derivatives, which takes an increased attention span for regular folk to understand.
It is not just our industry that has become more complex, just take a look at every monthly bill you currently pay and think of fifteen to twenty years ago and how much simpler those goods and services were back then. The combination of technology, legal rami-fications, desire for variety/choices, and wanting it yesterday has made for increasingly complicated processes. This can produce unintended consequences nobody thought of until they unfold or explode. As we mentioned a few letters ago the movie “It’s Complicated” did a great job of depicting similar dynamics regarding love and relationships. Not to mention it was well scripted, cast, and acted unlike many of Hollywood’s efforts.
With so much at stake regarding the economy and markets over the last several years, the ante for unintended consequences (UC) has been upped considerably. One of these UC’s occurred last May. The market had just finished an impressive three month rally ignoring the ominous news around Europe’s insolvent, yet entitled countries. Mid-day May 6th, the market started a free fall never seen before. It was a little sloppy that morning, but nothing exceptional. Within a couple of hours the Dow Industrials had gone from a hundred points down to nearly a thousand points down. It did regain some composure and closed off 337 points for the day. Some ETF’s (Exchange Traded Funds) traded over 50% below the previous day’s close.
The initial reason given for the event was someone’s “fat finger” pushed one too many zeroes for an already large trade. Five months later the Securities Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) issued a report indicating that indeed a large trade, high frequency traders (HFT), and the pulling of bids by many institutional players were the cause of the crash. This only a week after an extremely constructive rally topped out. Since we have been in the business most scary days have occurred after a distinct topping/distribution type process has occurred. For this event to unfold only a week after the top is made is worrisome. The crash of 1987 occurred nearly two months after the top was made and the action grew sloppier as we headed towards October 19th.
John Bates, Chief Technology Officer for Progress Software (video link), claims that the current environment is ripe for what he terms a “Splash Crash”. This would occur something like the Flash Crash, but affect more asset classes than just equities He believes currencies, bonds and commodities could also be affected. Some say he is fear mongering, others say it is inevitable. We personally would not discount it, especially if we had some dire news in a much sloppier trading market.
We think the point to take away is how complicated we have made the markets and how no one has a complete handle on all the factors involved within the tangled web. We have spoken many times of High Frequency Trading and naked short selling; now index/sector ETF’s have come under scrutiny as their numbers have increased significantly. Essentially there are not enough underlying assets for these vehicles to purchase, so they create derivatives to mimic the index/sector. More financial engineering is just what we need?
The SEC and CFTC have put in circuit breakers in an attempt to dampen the domino process that occurred during the Flash Crash and we are sure it will have some slowing effect. No one wants a dislocation of our markets (except maybe some terrorists?), but with the money that is made by creating all these vehicles the web becomes more tangled. Do you think Wall St. learned a lesson in 2008?
We do not believe that you as part of the investing public need to understand the intricacies of this possibility, but a conversation with your advisor on how your portfolio could be impacted is probably worth having. Wall Street appears to be playing a role of Dr. Frankenstein and Mr. Bates and others are just warning the villagers. Hopefully it turns out to be more Young Frankensteinish.
Chart Spotlight
On a cheerier note the stock market continues its march higher dismissing any and all potential issues, the most recent Egypt’s unrest. We wrote last time about the possibility of this being the start of a new Secular Bull Market (not totally convinced…yet) and now two important indices have regained the highs made in 2007. This is definitely good news for the Bulls and we consider these to be important factors in deciding how to allocate a portfolio for the rest of the year. The Nasdaq 100 and S&P Midcap 400 like the rest of the equities market have had a strong run since the first of September. The longer the market holds up the more convincing the Bulls become. Remember the stock market often accurately predicts the economy 6-9 months out. So is the market speaking or Ben Bernanke through the QE2 process? If the market is talking we should see a distinct improvement in employment over the next several months (January was mediocre at best). What is even more compelling is that the high in the Midcap index is an all time high! Definitely a data point for the bullish side of the ledger.
Did You Know
AVERAGE BULL MARKET PERFORMANCE - The bull market for the S&P 500 that began after the stock index bottomed on 3/09/09 is now less than 4 weeks away from its 2nd year anniversary. Through the close of trading last Friday (2/11/11), the S&P 500 has gained +96.5% since 3/09/09 (change of the raw index not counting the reinvestment of dividends). The last 10 bull markets for the stock index (going back to 1957) have produced an average “trough to peak” gain of +131.7%. Of the 9 other bull markets that have occurred since 1957, the shortest duration was 2.2 years. The average duration of all 10 bull markets since 1957 (i.e., the current bull market is the 10th) is 4.3 years (source: BTN Research).
Final Thought
“I didn't say it was your fault, I said I was blaming you”- The Key to Partisan Politics
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