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This was a bit of a curve ball. Five years after the flash crash, the Commodities Futures Trading Commission has filed a civil complaint alleging a man named Navinder Sarao manipulated the Chicago Mercantile Exchange's E-mini futures contract by using spoofing tactics, that is, efforts to place and cancel hundreds of thousands of orders with no intention of executing them.
This apparently went on for some time, beginning in June 2009, and lasting intermittently until the present.
What's getting attention is the CFTC is alleging that Sarao was active on May 6, 2010, the day of the flash crash.
Simply put, they are alleging that Sarao used a "layering algorithm" that set large sell orders in the E-mini order book, all at different price levels above the best asking price. There was very little chance the orders would ever be executed because they all kept moving as the market moved, but because these orders were so large they allege he was as much as 40 percent of all active sell-side orders on some days.
Now to the manipulation part. They allege he overloaded the sell side, which lowered prices. Then, when he stopped overloading the sell side (when he turned the layering algorithm off), the price rebounded. He profited from this temporary price volatility by trading the E-mini contracts. His daily profits on 12 specific days he was active, including the day of the flash crash, was approximately $6.4 million, or $530,000 a day.
There are additional spoofing allegations, but you get the point: Sarao attempted to cause a price drop, then took advantage of the drop by repeatedly selling the E-mini contracts and buying them back at a lower price. When the layering algorithm was turned off, he bought and sold the contracts as prices rebounded.
Bear in mind, there's nothing wrong with layering an order book with sell orders. Traders do that all the time.
However, it is different if you are putting out orders that represent false supply that is pushing the market down to cover your short orders. These were not bona fide orders, the CFTC is alleging. He had "cancel and close" orders, that is, as soon as the market came close to the order, it was cancelled.
It's not just the scheme, it is the size of it: on many days, the CFTC alleges that Sarao accounted for approximately 20 percent of total sell-side orders, and sometimes as high as 40 percent.
On the day of the flash crash, the CFTC alleges, Sarao put in orders representing about $170 million to $200 million in the morning and early afternoon, representing 20 to 29 percent of the sell-side order book. The orders were replaced or modified more than 19,000 times before being cancelled at 1:40 p.m., Central Time.
The CFTC's point: Sarao was at least partly responsible for the severe imbalance between buy and sell orders that was believed to be a major factor in the flash crash.
The SEC, in its report on the cause of the flash crash, named several factors, but also placed significant blame on an imbalance between buy and sell orders that caused a dramatic drop in liquidity on both the E-mini futures contract and the S&P 500 ETF.
However, a principle reason for the imbalance, the SEC report said, was that a large fundamental trader of a mutual fund complex initiated a program to sell a total of 75,000 E-Mini contracts (valued at some $4.1 billion) as a hedge to an existing equity position. The "mutual fund complex" sold these contracts with little regard for price or time... it just executed the order very quickly.
In other words, the "mutual fund complex" used a lousy algorithm. This caused a severe imbalance between buy and sell orders.
This is what bugs me: the SEC says this lousy algorithm sold $4.1 BILLION in E-mini futures. That makes the $170 million-$200 million in sell orders that Sarao allegedly put in seem like small potatoes. And remember, Sarao's orders were cancelled!
What's this all mean? My first reaction is, what took them so long? Five years to look into this? Even with the understanding that researching this kind of stuff is very difficult, it was an absurdly long time.
Second, looking for a single cause of the flash crash is fruitless. As Dave Lauer at KOR Group has noted many times, the stock market is a complex system.
All we can do is talk about contributing factors:
1) There was great fear on that day about the European debt crisis, with the euro going into a sharp decline about 1 p.m., Eastern;
2) there were very severe buy and sell imbalances midday, which were likely caused by several factors and participants;
3) liquidity dried up as some participants chose to back away from trading, or route orders to other venues;
4) market structure was rickety, with circuit breakers differing between the exchanges.
One thing is pretty clear: regulators need to get more sophisticated in how they analyze the market. How? Lauer (who has founded Healthy Markets, a nonprofit advocacy group for market structure reform) and others have described what is needed: take the data from the equities, futures, and options market, including dark pools and hidden orders, then have everyone synchronize their clocks to the microsecond, so everyone is on the same time.
Then you have a quick, easy way to find and police the markets quickly. You can't now because the data is in a million different places, with different time stamps. And no one knows what they're looking for!
We are finally in the heart of earnings season, and two clear trends are emerging:
1) Earnings have stopped dropping as more companies than normal beat estimates, and
2) Revenues are bad and getting worse.
Almost to a company, weak revenues are being mostly or largely blamed on the strong dollar, and with some justification: the Dollar Index rose almost 10 percent on the quarter, an amazing move.
I've held back on making broad comments on this because we haven't had many companies reporting. But now roughly 90 of the S&P 500 companies have reported. On Tuesday, we are seeing comments from several multi-industry companies that sell internationally to many different businesses.
And I don't like what I am hearing:
Dover, which makes drilling equipment, pumps, and refrigeration & food equipment, says revenues are 4 percent lower because of the stronger dollar;
Kimberly-Clark said foreign exchange would cut their 2015 operating profit by 9 to 10 percent;
Illinois Tool Works, which makes automotive parts, food equipment, and electronics all over the world, is reducing its 2015 full-year earnings guidance by 15 cents a share to reflect current exchange rates;
United Technologies said earnings of $1.58 would have been 7 cents higher were it not for the impact of the dollar;
Harley Davidson said sales fell 4 percent, hurt by currency and lower shipments; Morningstar estimated negative currency reduced revenues by 3.5 percent.
Dupont said sales were down 9 percent, with the majority of the drop due to the strong dollar.
Here's what's alarming: the impact on revenues from the strong dollar is much more significant than analysts had estimated.
That's why revenue estimates for the S&P 500 keep dropping. They are now expected to decline 3.3 percent for this quarter, on March 31 they were expected to decline only 2.6 percent, according to Factset.
It's unusual for earnings or revenue numbers to keep dropping once the quarter begins.
How did this happen? The analysts are not currency strategists: they have no idea what the exchange rate will be in the next few months.
When analysts estimate earnings, they typically use a static exchange rate...that is, whatever it is that day.
And the dollar has significantly strengthened since many analysts made their estimates.
When companies report, they will use a weighted average exchange rate for the period they are reporting for. But unlike the analysts, they already know what the currency effects are when they report.
Here's the issue: "the dollar is killing us" has become "the dog ate my homework" excuse for every company missing on revenues; can we sort it out?
I think we can. Factset has looked at the revenue from companies that get more than 50 percent of their sales outside the U.S. There is a very clear hit to revenues from companies that get a majority of their sales overseas:
Q1 S&P 500 revenues
More than 50 percent of sales outside the U.S.: down 10.8 percent
Less than 50 percent of sales outside the U.S. up 0.1 percent
Wow. Multinational corporations—those with more than 50 percent of sales outside the U.S.—are clearly having bigger revenue hits than those that operate largely in the U.S.
The conclusion: the stronger dollar has made U.S. multinationals less competitive.
That, as Nick Raich at Earnings Scout and others have noted, is why U.S. stocks are lagging their global peers in 2015.
Confusing markets: if the trend is your friend, what is the trend?
The Dow was down 279 points on Friday, and on Monday at midday it's up more than 200 points. Huh?
Here are three explanations I have heard for the market action in the last two days:
1) Stocks cannot stay down for long because there are no palatable alternatives.
2) Why were we down on Friday in the first place? Greece, China? China made it clear it's going to keep stimulating when it announced a cut in the reserve ratio.
3) We're actually not moving much at all, we have been stuck in a trading range all year, between roughly 2000 and 2120 on the S&P 500.
My point: if you're not a bit confused, you're not paying attention.
Take China. I've noted that Chinese monetary authorities have made it clear they are going to keep stimulating, but Chinese regulatory authorities seem afraid the stock market is in a bubble, and they ban margin financing in over-the-counter stocks. Confusion!
Or take Apple. Apple closed below its 200 day moving average on Friday, with lots of hand wringing. On Monday, it shoots the lights out, up 2.5 percent midday.
Then we have earnings. I've said several times that analysts appear to have "wet the bed" and reduced earnings estimates too aggressively. Now the numbers are coming in and many more are beating than usual.
What to do? For the moment, the best advice I am hearing is to sell rallies and buy declines, until the range breaks one way or another.
Over the weekend China reduced the reserve requirements for banks by 1 percentage point, from 19.5 percent to 18.5 percent. That will allow more funds held by banks to be available for lending; estimates are it could free up 1 trillion yuan (about $160 billion).
What's not clear is how much of that money would find its way into the stock market.
This is the second time the Chinese have cut the reserve requirements this year. The People's Bank of China reduced it from 20 percent to 19.5 percent on Feb. 4.
Next up is a likely cut in interest rates. The Chinese cut the one-year lending rate on Nov. 21, 2014 by 40 basis points, from 6 percent to 5.6 percent, then again on Feb. 28 by 25 basis points, to 5.35 percent.
That November cut, the first in more than two years, coincided with the great rally in Chinese stocks which began at the same time.
That's when the Chinese started talking aggressively about "stimulus," which is being carried out by lowering rates and reserve requirements.
So why was the Shanghai Index down 1.6 percent in China? It's likely because of the continuing fallout from last week's announcement that regulators would ban margin financing in over-the-counter stocks.
This is part of the problem: Policymakers talk stimulus, which encourages money to go into stocks, but they don't want the market to get too hot, so they pull back in other areas.
Weakness is setting in in Europe on concerns of a Greek exit. We're seeing a fairly clear flight to safety. German and French bond yields are plunging. The German 10-year is now yielding 2 basis points! Peripheral debt in Italy, Spain, and Greece is up by double-digits.
European banks are notably weak.
After the close in China, regulators instituted a crackdown on stock margin trading in over-the-counter stocks. Because the market was closed, the news was not reflected in the markets there.The Shanghai Index was up 2.2 percent. However, China ETFs trading in the U.S. are lower.
Also on Thursday, Blackrock, KeyCorp, Sherwin-Williams did the same. Earlier in the week, most of the big banks were also a bit light on revenue expectations: Bank of America, US Bancorp, and PNC Bank.
Wake up! There's a slow meltup going on.
I know, another snoozefest. Low volume, the CBOE Volatility Index at 13 and change, near the lowest level of the year.
But look around you. Earnings season has begun, but instead of falling apart because of the negative earnings environment, the S&P has rallied 1.25 percent since Alcoa reported earnings after the close last Wednesday.
1) The S&P 500 is at its highest level since early March, and only a few points from its historic closing high of 2,117.39 on March 2;
2) The Russell 2000 is at an historic high;
3) The S&P Midcap is also poised to surpass its old historic high of 1,539.61 on March 20
Oh sure, we've had several periods where there's been a few sharp sell off for an hour or so in the last few weeks, but it always bounces back.
As for earnings, the dreaded season is upon us. Bank of America was light on revenues, but it's only down fractionally. Charles Schwab talked about slower trading activity, but earnings were in-line, it's up fractionally. Delta talked about the problem of the strong dollar as revenues were a bit light, but it's up nearly two percent.
In other words, earnings are coming in-line with reduced expectations, and the market is shrugging them off.
Overbought: international and energy. One other thought: the action has been in global markets...that's where the money has been going. Huge inflows in China and Emerging Markets, and Europe.
But these are also dramatically overbought. Look at these countries year to date:
China (Shanghai) up 26%
Germany up 24%
Spain up 15%
Brazil up 9%
Heck, even BRAZIL is up almost double digits, compared to two percent for the S&P 500!
You really think there is a lot more room there?
Finally, here's the issue of the moment: what to do with the oil breakout? Much of the gains today are in energy, as oil (West Texas Intermediate) breaks to a new high for the year. Big Energy names like Halliburton, Anadarko Petroleum and Cabot Oil & Gas are up two to three percent again.
The problem is, all these stocks have been on a tear since oil bottomed in mid-March.
Bespoke, in a note to clients today, noted the double-edged sword: energy has broken the downtrend, but all the leadership stocks—including those above—are overbought, in many cases VERY overbought.
Bespoke's advice: "For names that you're interested in, wait for a cool-down period sometime in the next week or so, and then pounce on the long side."
Is this the week initial public offerings finally get going? It's been a lousy start to the year for IPOs. In the first quarter of 2015, there were 34 deals worth $5.4 billion, half of the 64 deals worth $10.6 billion in the first quarter of last year, according to Renaissance Capital.
That's pretty poor, but here's one important point: The IPOs that have been issued are doing well. The Renaissance Capital IPO ETF, a basket of roughly 60 IPOs that have recently gone public, hit a new high Monday.
This may be the week the number of issues finally starts picking up. There is roughly $1.2 billion worth of deals seeking to price, the second biggest of the year, after the week of Feb. 2, when $1.3 billion priced due to the large master limited partnership deal involving Columbia Pipeline Partners.
Read More Venture-backed IPOs hit lowest levels in two years
Overnight, Ottawa tech company Shopify filed for an IPO of up to $100 million in New York and Toronto.
Also overnight, a well-regarded cancer immunotherapy firm, Aduro Biotech, priced 7 million shares at $17, well above the initial talk of 5 million at $14 to $16. The company leverages patients' immune systems to slow the growth and spread of tumor cells.
On Wednesday evening, three other companies are pricing: Etsy, Party City, and Virtu. All of them (oddly) are from the New York City area. All three have market caps exceeding $1 billion—$2.4 billion for Virtu, $1.9 billion for Party City, and $1.8 billion for Etsy. And while all are in different spaces they all have similar, favorable characteristics: strong cash flow and a leadership position in their respective markets.
Hong Kong rallied to a 7-year high. The China H-shares—the Chinese shares listed in Hong Kong—have seen huge turnover recently. Mainland Chinese investors who have seen gains in the Shanghai and Shenzhen exchanges seem to be rotating out and into Hong Kong, which has lagged the mainland. There has also been very large volume in ETFs that track Hong Kong-listed shares.
1) Europe rallied after Greece paid off its IMF loan installment. Portugal's market is up 31 percent this year, French stocks have gained 21 percent, and the German DAX is up 23 percent.
2) Not many retailers still report monthly same store sales, but among the few that do, the results for March are a bit disappointing.
L Brands was a winner, posting comparable store sale that were up 9 percent, way ahead of expectations. Margins also improved, and the company's Victoria's Secret and Bath and Body Works brands both showed strength.
Costco reported negative 2 percent comps, its first negative comp since Aug. 2009. Obviously the gas priced decline was an issue for the retailer, but even excluding the crude impact, the core same store sales number was only up 4 percent, below expectations.
Overall, I'm a bit disappointed. We had a very early Easter, and when that happens, March is usually a bit loaded at the front end. Let's hope things turn around as the weather improves.
One item that was not disappointing: Constellation Brands, which not only beat but reported an 11-percent increase in beer sales (in constant currency). Some may have expected more, but that is a pretty good number. Mexican beer like Corona and Modelo is on fire!
Constellation stock at an historic high.
While Alcoa is not the big name it used to be, and it is arguable that the earnings season does not really start until banks begin reporting next week, it still represents the kickoff to earnings season, at least among old-timers.
And since we have a huge new data sandbox to play in, I asked our partners at Kensho what happens in the quarter when Alcoa reports earnings above or below expectations. Here's what the data revealed:
Since 2005, Alcoa beat 16 times, and missed 23 times.
When Alcoa did beat, the S&P 500 was up 75 percent of the time for quarter and averaged a return of 4.4 percent.
When Alcoa missed, the S&P 500 was up 65 percent of the time, but the average return was -0.24 percent.
In other words, an Alcoa beat does seem to correlate with a somewhat stronger S&P 500.
Earnings season does not look good, but are some stocks washed out and ready to bounce?
I've noted for weeks that we are in an earnings recession, with two consecutive declines now expected for profits in the S&P 500, according to FactSet. First-quarter earnings are expected to come in 4.7 percent lower, while second-quarter earnings are expected to come in 2.1 percent lower. Third-quarter earnings are expected to come in 1.6 percent higher.
Wall Street is gripped with this frenzy that earnings will be much weaker than expected even a month ago.
The good news is many stocks may be reflecting this disappointment already and may be ready to stabilize and even bounce.
Despite earnings, investors cannot help but notice the continuing impact of the strong dollar on tech revenues.
In a first for a U.S. stock exchange, Nasdaq OMX Group on Thursday agreed to pay $26.5 million to settle a lawsuit involving its bungling of Facebook's IPO.
Many pros scoffed at the notion that Navinder Sarao was the sole culprit of the spectacular plunge on May 6, 2010.