Learn from the Blame Game - Weekly Blog # 546

Mike Lipper’s Monday Morning Musings

Learn from the Blame Game

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

As is often the case, media and politicians look to blame "the guilty" for any perceived negative event. Clearly an 1100 point drop in the Dow Jones Industrial Average (DJIA) on Wednesday and Thursday was caused by bad people and their bad actions. Thus, when the bad people are found and punished for their bad actions we will avoid future problems.

Except, that means we have learned nothing from the event that will help us avoid similar problems in the future. Those who believe that only evil forces created the problem forget the only true rule of market places: The production of Humility is the only guaranteed result in the market place.

Contributing Factors 
We should have been more aware of the implications of structural changes in the fixed income, equities, and currency markets. These were regulatory changes designed to prevent the public from a government bailout of collapsing major financial institutions, while also lowering transaction costs.

1. Major Commercial and Investment Banks were required to increase their capital buffers and restrict portions of their trading and market making functions. This had twin impacts. First, liquidity was reduced in all tradeable markets, particularly in the fixed income and currency markets. Second, as this was quite profitable in most periods, it reduced the earnings power of these institutions. Thus, some market risk was shifted from the market making institutions onto the backs of investors, creating more intra-day volatility and price gaps between trades. 
2. One of the big differences between the price patterns of stocks on the listed stock exchanges and those traded over-the-counter on NASDAQ was that on the listed exchanges there was a positive responsibility on the part of the floor specialists to maintain orderly markets (In the 1987 fall at least one specialist took this obligation seriously and went broke trying to maintain an orderly market in a steep decline). As an offset to the risks involved in maintaining an orderly market, the specialist had a material information advantage to keep the book registering incoming orders. Thus, most of the time Specialists were quite profitable. Some viewed these profits as being taken from investors in higher transaction costs. To my mind, the forgone profits were worthwhile as payment for liquidity. The SEC believed this was an unfair advantage and pressured the New York Stock Exchange to effectively eliminate the Specialists. Not surprisingly, investors paid the price for the drastically out of balance pressure on non-price sensitive sales compared to those gotten by reluctant buyers last Wednesday and Thursday. We should have expected this. 
3. Daily transactions in Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) are mostly done institutionally by managed accounts and professional traders. During the trading day these players use ETFs and particularly ETNs as part of complex transactions to offset other securities. At the end of the trading day they need to balance their positions, and with the known end of exchange trading they become even less price sensitive. Thus, the last twenty minutes of trading often encompasses the biggest price swings of the day. 
4. Most of the pundits have focused on the rise of interest rates, which have been telegraphed for some time. I believe that there were two other partially related things happening. First, the rising budget deficits expected in the US, Italy and elsewhere will create more government paper, crowding out some commercial needs and driving interest rates higher. Second, credit conditions could be peaking as the faster than expected economic expansion slows. There are signs of this with Sears and various other companies in Europe. Thus, in my opinion the issue is not primarily interest rates, but the future availability of credit capital. 
5. One of nice things about a command economy is that it may be easier to control than a multi-party led one. The central government of China is concerned about the amount of debt that has been produced in their country. It is well known that they have instructed their government-controlled banks and affiliates to cut back on debt extensions. This is not new. One of the ways the government-controlled banks reacted was to have Asset Management Companies (AMCs) take over their distressed loans. The AMCs raised a lot of capital through the Hong Kong markets and those domiciled in offshore locations. This high rate paper was purchased by what may be called "yield hogs" throughout the world. One suspects that some of these loans won't be paid back on time and in the full amount. 
6. For tax purposes, the US mutual fund year is over in October. Many equity funds in net redemption have sold some of their high-priced holdings to meet cash demands. To reduce their shareholders’ taxes, some are selling their losing positions into a declining market.

Working Conclusions:
We have experienced a somewhat normal cyclical contraction that delays normal secular growth patterns. All of the contributing factors were known for some time and thus if investors were surprised by the recent decline they are the "guilty parties" for lack of sufficient risk awareness.

In the latest American Association of Individual Investors (AAII) weekly sample survey, bullish investors dropped to 30.6% from 45.7% the prior week. One can envision the most volatile group going overboard with concern for the next six months. While no indicator has a perfect score on predictability over time, those that are wrong more often than they are right are more predictable. The AAII summary is a well-established negative (reversed) indicator.

This up and down movement lends itself well to adopting a timespan approach. I would be happy to discuss how to use this approach with a limited number of subscribers, tailored to your own needs.


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