RECKLESS
As early spring arrived, the prevailing mood was optimistic. Most technicians were bullish and fundamentalists were encouraged by a growing number of signs that the U.S. was healthy. It had been nearly a year since Fed Chairman Bernanke’s vision of “green shoots” that would transform the scorched earth of the market into a lushly verdant, flowering market rally and recover much stock market wealth that had been lost.
Investors who stayed invested through 2009 participated in the bull market and regained enough confidence to resume an almost normal level of living and spending. The stench of the Madoff scandal was fading and the promise of a new administration began to restore trust. According to official measurements, the recession had come to an end. Investors, who were frightened, fled equities for bond funds and missed the recovery but may now have the last laugh.
The market has now given up earlier gains and stands about 3% below the end of 2009. Recent weeks have been a gloomy time throughout the world, with the global financial crisis gathering new steam and raising doubts in the minds of investors as to whether we are going to once again descend to the desperate days of late 2008 and early 2009. Many believe that we are not out of the woods, as unemployment continues at high levels, housing remains depressed, and auto sales remain at an annual sales rate still some 30% below pre-recession highs. Wall Street’s mood now matches Main Street’s pessimism.
Market volatility has risen sharply as global focus centers on Greece, Hungary, the future of the Euro, a slowdown in China and North Korean war mongering, while two huge acts of nature – the Icelandic volcanic ash cloud and the BP oil spill damage serve as the coda to this unhappy symphony of fear and despair.
Added to the problems with economic fundamentals were market technicals. On May 13th, the market experienced a “flash crash”, falling by about a thousand points on the Dow Average within a 12 minute period. Some stocks plunged to a penny, while the blue chip Procter and Gamble fell from $62 to $39 per share in a matter of minutes. This hideous gyration was originally blamed on human error – a trader typing “Sell” instead of “Buy”, or “Billion” instead of “Million” – but as of now, a single cause has not yet been established, despite intensive scrutiny by regulators. Their failure to figure it out has diminished confidence in those regulators yet again. What’s going on?
Many investors and the public at large believe that the markets have turned into a giant gambling casino where uninformed bets rather than careful investments can be made on almost anything. The capital markets have mutated into computer action games.
Gambling is one of America’s pastimes. People play poker; bet on games and races, in person and on-line; participate in office pools; everyday golfers play for money called a Nassau bet; and states use lotteries and off-track betting to supplement income to pay for education and other social needs in lieu of higher taxes. Today, Las Vegas is trying to change its image from a sin-city to a family theme park. People may like to gamble and have fun with their own money but clearly fail to see the fun when banks and financial institutions put customers’ funds at risk and lose it, thus endangering the economic health of the world. No one wants the Federal government to use taxpayer money to be forced to rescue reckless institutions.
New products and activities including Exchange Traded Funds (ETFs), Credit Default Swaps, High Frequency Trading as well as other derivatives coupled with computer facilitated on-line trading have stepped the pace up a notch. A few weeks ago, the Commodities Futures Trading Commission (CFTC), the Federal regulatory body overseeing commodities, allowed the creation and future sale of new derivative futures contracts based on movie revenues. Institutions and individuals will soon be able to bet on the future attendance of a given film before it’s released, wagering whether a new Johnny Depp film will outdraw Shrek. Promoters of this product believe it will help movie production companies to hedge risk, but for the public it will be just be another reckless gamble rife with potential fraud and insider trading.
“High Frequency Trading” (HFT), conducted by large firms such as Goldman, Sachs as well as small firms unknown to the public, apparently represents a large part of daily market activity and was heavily involved in the flash crash of May 6th.. Responding to that event, The New York Times ran an article which described a “humdrum office of a tiny trading room …..workers in their 20s and 30s in jeans and T-shirts quietly tend high-speed computers that typically buy and sell 80 million shares a day. But on the afternoon of that May day …someone walked up to the computer and typed the command HF STOP, which meant: sell everything, and shutdown.” According to the article, across the country similar firms did the same thing which sent chills through the financial world.
With practically all trading on world markets now done electronically, large high-speed computers can be programmed to read accumulated buy and sell orders (order flow) seconds before the trades take place, anticipate whether in the next few seconds a stock is likely go up or down, and quickly and instantly enter an order. Some call it “front-running”, a hitherto illegal industry practice, but regulators look the other way. Most people would agree that this is not the way markets were designed to function, and it is reckless to allow a situation where these “accidents” happen. In past times, it was panicked human investors who would react to bad news by dumping stock and selling en masse, but in today’s markets, it’s the technicians who program the computers to feel the fear and emulate the same knee-jerk human behavior.
It’s thought that high frequency trading (HFT) now accounts for 40-70% of all trading in the market, with some of the largest firms trading as much as 1 billion shares a day. The founder of one of the largest trading firms called them short-term bets and said that his firm typically held stocks for 11 seconds and had not had a losing day in four years. This is clearly not the buy and hold investment strategy that guest experts on CNBC traditionally propound. Investors who talk of the long term and fundamental values embedded in well managed companies are living in a parallel but extremely different universe.
Defenders of unbridled laissez-faire capitalism justify every market product and function as being essential to market liquidity and economic growth. This reckless thinking to support reckless behavior threatens to destroy the capital markets as they were purposely designed: to efficiently facilitate liquidity, stability, economic growth and to allocate private capital to industry. On the contrary, we see some periods of severe illiquidity, instability, economic stagnation, and biased allocation of capital.
Increasingly over the past decade, markets and the stocks and products within them have taken a dramatic turn to short-term rather than long-term investments as hedge funds and quantitative traders have replaced traditional long-only mutual funds as the source of greatest market liquidity. Warren Buffett, who has the reputation of being the market’s most respected practitioner of fundamental long-term value investing, seems to be to have had his best recent investments as the bottom-fishing buyer of last resort in a panic-driven market – being the buyer when computers were sellers.
Responding to the confusion and volatility in the markets, generalized public anger has created upheavals within both Republican and Democratic parties. The modern financial system seems unintelligible to the public and to many members of Congress and their staffs as well. The size and complexity of global financial markets presents an enormous information gap.
In response to the Crash of 2008, and to the mini-depression that continues on Main Street and around the world today, Congress crafted a new financial regulation package (FINREG) aimed at insuring that an event of this past magnitude will never happen again. A compromise bill will be voted on soon by each body of Congress. What has emerged obviously has both supporters and critics. The New York Times says it all: “ACCORD REACHED FOR AN OVERHAUL OF FINANCE RULES: Historic Deal Expands Federal Authority to Curb Risky Wall St. Practices.”
The new bill tries to take aim at the root cause of the Crash of 2008, and throws in a bunch of other ancillary features, but I remain skeptical that that root cause has been correctly identified. The established narrative of the Crash includes excessive leverage, sub-prime mortgage lending abuses, consumer fraud, and reckless proprietary bank trading, but the new bill does not appear to deal with financial institution leverage and capital requirements, nor does it establish clear jurisdiction and regulations over Credit Default Swaps. In my opinion, these and their interrelationship were the principal forces that brought about the destabilization of the financial system. As I wrote in 2008, it is my very strongly held opinion that Secretary of the Treasury Paulson’s push of Lehman Brothers into a bankruptcy proceeding was the straw that broke this camel’s back, and was in itself reckless, hasty and politically motivated. It compressed what might have been a long-term workout problem into an uncontrollable short term cataclysm. No one should forget that Madoff was able to perform a 20 + year massive customer swindle despite being subject to SEC and NASD/FINRA regulation. Those with a will can often find a way.
No other country in the world to my understanding embraces unbridled, unchecked, free-market capitalism with the religious-like fervor as we do in the U.S. We have a society that seems to worship money and celebrity as its core value. Our society thrives on and our economy depends on excessive and conspicuous consumption, and produces a mindset of greed and entitlement that goes unchecked and unregulated in this new FINREG bill.
Public fury now being directed at politicians and business leaders alike seems to have broken the political structure of each party and threatens to replace incumbents with a weird and motley assortment of political newcomers with radical views. Unpredictable, inflexible and un-manageable may describe the political climate in our current environment.
Thus, the economic and market environment is likely to see an increase in volatility and uncertainty as we move forward in this current election cycle. There is some softness developing in the consumer sector of the economy and small business is thus far failing to fulfill its role in job creation. We read that banks are not lending to small business. Now that we are emerging from the depths of the recession, common sense dictates that we keep going forward with programs that will stimulate job creation and keep the economy on track to recovery. No one knows this better than Fed Chairman Bernanke, whose reputation is based on his expertise about the Great Depression and the serious consequences that occurred when economic fiscal and monetary stimulus was stopped prematurely.
Unfortunately, political sentiment is moving towards “austerity” on a grand and international scale. Simplistic assumptions by the general public are forcing Congress along a path of rabid fiscal conservatism, pushing towards a premature deficit reduction program. Just last week, the Senate rejected an extension of unemployment benefits leaving 1,000,000 unemployed with nothing; an extension of the housing credit; and aid to beleaguered states now in the process of discharging hundreds of thousands of employees. The Federal Government can not be run like a household in Iowa or Maine, or a town in Connecticut, scrimping and saving to live within the weekly paycheck or annual revenues. It’s got to reach out to all 50 states and towns within them, and keep spending on the necessities. Both the ratios of federal and external debt to GDP rank far below most other countries of the world and the situation is less dire today than the media and fiscal conservatives would have us believe but, yes, it is a long-term problem.
Economic life in a global economy is extremely complicated and it is clearly beyond the comprehension of the electorate. We all love our Democracy, but people who vote really have to understand what’s going on and what they’re voting for. A recent respected poll proves, contrary to widespread views, that citizens overwhelmingly want an active government in controlling the oil spill and running Social Security and Medicare for example, but the media runs with the story and old video clip of someone screaming “Keep the Government out of my Medicare!” It is my great fear that because of the threat of not being re-elected and trying to appeal to the vague, undefined and uninformed anger of their constituents, Congress is soon to embark on their most reckless behavior yet, with serious consequences for the future.
Investing in this economic maelstrom is as difficult as at any prior time in my 47 years in Wall Street. However, I do believe in a long term and I do believe that equities rather than bonds are the way to participate in the evolutionary process towards that long term. Changes in economic and civil life offer adaptive ways through innovation to participate in advances in health care, energy and communications to name but three sectors, and emerging markets allow an involvement with the world outside of the United States. The continuation of a low-interest rate policy provides low income yields and I continue to believe that selling short-dated covered calls against an underlying quality equity portfolio is a low risk method of income generation.
Peter R. Mack
June 26, 2010
Peter R. Mack is a principal of a SEC registered broker/dealer firm. The ideas presented here are his own personal thoughts and are offered for educational purposes only. Mr. Mack makes no representation as to the accuracy or completeness of the information contained herein and the reader should not rely on any information as the basis for any investment decision. Mr. Mack may, from time to time, have long or short positions in any security mentioned herein.
