IPO market has been flashing a strong yellow light for months.» Read More
JPMorgan analyst Marko Kolanovic is having his moment of fame.
Kolanovic is the global head of derivative and quantitative strategies. He got considerable attention right after the Aug. 24-25 selloff by publishing a report saying that "price insensitive" programs might cause repeated selloffs.
Yesterday, he got more attention by claiming that "technical selling pressure" from trading firms was largely completed, and that the trend would be toward buying in the days and weeks ahead. The report—out in the middle of the day—was even credited by some with the 200-point rally in the Dow.
Thursday's report also contained a long section analyzing the events of Mon., Aug. 24, when the Dow dropped roughly 1,100 points in the first five minutes of trading.
Kolanovic blamed a good part of that drop on a lack of liquidity in the marketplace, as well as to a herd mentality by traders desperate to buy protection against further market declines at any cost.
Kolanovic notes that the seeds of the selloff were planted the night before. On Sunday night, Aug. 23, a large drop in equities in Asia triggered a drop in index futures in Europe and the U.S. U.S. stock futures went down (7%) prior to the U.S. open.
Panic buying of protection. That, Kolanovic says, caused traders to panic and seek to buy protection in any form, including put options. Lots of it. They got this protection from dealers, who were overwhelmed with the need to sell protection to traders.
When a dealer sells a put option, the dealer is long the market. If the market moves down and the option goes "in the money" the dealer needs to sell to stay neutral. Normally this does not matter, but when you have massive amounts of options hedging that hedging itself will move the market.
These long positions from the dealers got larger and larger, Kolanovic says. Those dealers, to protect themselves, needed to "dynamically hedge", meaning if the market moved down, they needed to sell as well.
And that was a part of the problem: as the market opened down big, dealers were forced to sell as well.
Lack of liquidity. A second problem was a lack of liquidity, which means that there wasn't enough traders willing to buy all the stuff everyone wanted to sell: "a crash would not have happened if there was sufficient liquidity in the marketplace to absorb these flows," Kolanovic said.
How did that happen? A good part of the trading and hedging occurred in the pre-open hours, when there is poor liquidity. Also, the last two weeks of August is typically light on volume.
In other words, traders dumped large amounts of stock at exactly the wrong time.
Why? Why sell into no liquidity? Was there some fever that suddenly struck the trading community that caused them to make colossally stupid sales when there was no liquidity.
Well, in a way, yes. There was a fever. They had to sell, or at least that is the implication.
Look at this way: you are a trader responsible for managing risk at your firm. Suddenly you have outsized risk. You are through your risk limits, and your job is to stay in your risk limits. You are in danger of losing a lot of money, and worse, you are in danger of getting fired if you do nothing.
So you need to flatten your books, which, in plain English, means selling. In this somewhat panicky situation, they are not necessarily looking around considering the health of the market or the participation of other traders.
Market makers and high frequency traders. Kolanovic also briefly mentions the role he believes market makers and high frequency traders (HFTs) may have played in the decline.
He notes that there were extreme dislocations in the market going into the open and in the first 15 minutes or so:
1) Only about half of S&P 500 stocks were opened on NYSE by 9:35 a.m.;
2) 765 stocks in the Russell 3000 were down more than 10 percent on an intraday basis;
3) There were 1,278 trading halts for 471 different ETFs and stocks.
Because of this, it was not possible to calculate the value of many ETFs, or hedge or trade ETFs and stocks at a 'correct' price.
He notes that HFTs and other high-speed traders have models that essentially shut down their systems when they detect extreme pricing anomalies that may be incorrect or erroneous. This is a safety design that essentially says, "Can some human take a look at this and see if this stuff is pricing correctly?"
This certainly happened that morning. Many market participants withheld liquidity when they weren't sure what the prices were, or weren't sure if they were correct.
Is Kolanovic's analysis accurate? I think his key points about a rush to buy protection and a liquidity crunch are indeed components that exacerbated the decline.
However, don't kid yourself—the markets were going down, first and foremost on the fundamental issues of weakness in China and uncertainty about the Fed's policy on raising interest rates.
In a sense, this is oddly reminiscent of the 1987 crash report—which many blamed on "portfolio insurance." Markets were going down no matter what, and we are really debating about collateral effects that relate to liquidity and market structure.
What can be done? That doesn't mean we should ignore the fact that the market frayed around the edges. What can be done to tweak the system to make it work better on days of extreme volatility, like Aug. 24?
Kolanovic does not go into a discussion on this, but based on my own discussions with dozens of market participants in the past few weeks, I have a few observations.
They fall into three buckets:
1) improving liquidity. Kolanovic is certainly correct in noting that lack of liquidity was a big problem.
a) Almost everyone agrees that the volatility would have been lower if all the exchanges had opened at the same time.
One major problem was that parts of the market were open, but other parts—many of the NYSE listed stocks—took several minutes to open.
This allowed NYSE-listed stocks to trade away from the NYSE at widely different prices.
This is an age-old debate. The NYSE still uses a hybrid model, employing electronic trading and floor based designated market makers (DMMs) to open and trade stocks during the day.
So the argument boils down to this: should we just allow an all-electronic open everywhere?
The NYSE has historically opposed this, arguing that investors get fairer pricing in times of high volatility by having humans price the open, and if that means it may take a few more minutes past the open, so be it.
The NYSE has argued that the "just get it open" mentality can be dangerous, that by waiting to get better pricing retail investors—who are the ones who typically get the opening price—would be better served.
Would the markets have had less volatility on August 24th had there been an all-electronic open? I don't know, but I do think it is likely that the system-wide circuit breaker...a decline of 7 percent in the S&P 500....would have been triggered. That would have created a 15-minute pause.
Would that have calmed the market quicker? I don't know. Perhaps.
But it's unlikely that the exchanges will all open all their stocks at the same time; the markets are simply too competitive. No one is going to wait for anyone.
b) how can market makers be prudent, but more active? Kolanovic talked about market makers and HFTs shutting down when the data is uncertain...how can they get more certainty and not shut down?
One thing that's very important to understand about market makers—whether they are on options desks or HFTs or NASDAQ broker/dealers or Designated Market Makers (DMMs) on the NYSE floor—is that they play a game of pennies. They eke out small profits every day.
But history is littered with market makers who went out of business on disastrous days, when they committed massive liquidity and got killed.
So the retiscence is understandable. The obligation of market makers to provide "fair and orderly markets"—an obligation that has been considerably diluted over time—does not include the obligation to go out of business.
c) can the opening rules for the NYSE be improved? Many DMMs had to open stocks manually on Aug. 24. This was no problem when most DMMs had only three or four stocks, but it's difficult to get everything open in a timely fashion when each DMM now has 40 or more stocks. What could help them open stocks quicker, but still fulfill their obligation to find the best price?
2) improving regulation. After the 2010 "flash crash" the entire industry created individual stock circuit breakers, known as "limit up, limit down" (LULD) that halt trading in stocks for 5 minutes when they move more than 5% percent in a rolling five-minute period (the band is widened to 10 percent in the first 15 minutes of trading).
Those circuit breakers have worked well, but on an extreme day a huge number of halts (more than 1,200) definitely caused a problem.
Is five minutes the right amount for a halt? Should it be shorter? Is there a better metric that can be used? For example, why just use a time period if there is the same imbalance of buy and sell orders? Why not use a metric that says, we have to wait until a certain amount of buy orders are available before we reopen when there is an excess of sell orders?
c) changing the practice of market orders and stop orders. Dumping market orders into the exchanges was a problem on Aug. 24. There were many market orders that got executed at prices way below the prior day's market.
People who put in a market sell order on Aug. 24 were understandably upset when they sold down 10 or 20 percent. You can almost hear them say, "I wanted to sell, but I didn't want to sell down that low!"
What could be done? Market orders and stop orders that become market orders arguably should no longer be used. Instead, every order should have a limit, even if it's 10 percent away. That way, no one is surprised.
I'm sure there will be other recommendations. The SEC's Advisory Committee on Market Structure will also undoubtedly address some of these questions in the months ahead.
Whatever is done, let's not lose sight of the fact that August 24th was a very unusual day. There was something akin to a genuine panic among market participants in the pre-open, and nothing was going to prevent a big drop when the markets finally did open.
Thank you, Janet Yellen, for finally taking a side and clearly stating that an interest rate hike seems likely sometime this year.
And thank you for finally clarifying the sudden emphasis that was placed on developments abroad in the last FOMC statement.
Specifically, thank you for this clarification: "The Committee is monitoring developments abroad, but we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy."
Yellen is helping the banks this morning on higher interest rates prospects. This is not only important for banks, it's important for the S&P 500.
Bank earnings estimates have been under some pressure recently on the inability to realize higher rates.
More importantly, investors are relying on higher bank earnings to balance out the disastrous decline in earnings from energy companies. There are precious few sources of earnings growth right now.
This was another lackluster trading session, characterized by the utter indifference of buyers, despite stocks being down three of the last four days.
I've been talking a lot about the drying up of buying interest lately. There's several reasons this has been happening:
1) Stocks have been drifting lower since the Feddecision. A small but vocal minority (including Bill Gross) have insisted that the market might have been in better shape had the Fed done "one and done" and guided more positively on the U.S. economy.
Since then, we have a global marketplace that has taken another modest downturn on the exact same global slowdown concerns that existed prior to the Fed meeting, only this time the "global slowdown" story has the Fed imprimatur.
In other words, the Fed has successfully "infected" the rest of the world with its concerns over "recent global economic and financial developments."
2) Another group agrees that the market has been drifting lower since the Fed decision, but that the Fed was right and that not only has Chinabeen slowing down, recent economic data indicates the U.S. has been slowing as well.
They point to a series of recent fairly large economic misses:
This camp generally agrees that the Fed may have missed its opportunity to raise rates a few months ago, but with some signs of slowing economic growth, now was not the time to do it.
3) A third group notes that buying interest is weaker because it is obvious that weaker global growth is being manifest in: a) lower commodity prices, and b) negative revenue growth.
They're right. I noted earlier today we are heading for four straight quarters of negative revenue growth:
(S&P 500 revenues)
Q1: Down 2.9%
Q2: Down 3.4%
Q3 (est.): Down 3.3%
Q4 (est): Down 1.4%
We haven't had three quarters of negative revenue growth since 2009; we haven't had four quarters since the financial crisis.
This will be the big story for the remainder of the year.
Volume yesterday was slightly on the heavy side, but it's not the selling I'm concerned with, it's the buying. Or the lack of it.
Is "buy the dip" dead?
With the exception of one or two days, there has been precious little buying interest since the three-day drop in the markets from Aug. 21 to 25.
And why should there be? The markets already have had to deal with the uncertainty of not knowing when, if ever, the Fed is going to raise interest rates.
What bulls need now is some evidence that "buy the dip" does not turn into "sell any rally." Two things are necessary to avoid that.
1) Some evidence the global economy is not falling apart, starting with better data on China, which we did not get overnight. China's Flash Manufacturing PMI came in at 47.0, below expectations of 47.5, its seventh straight month of contraction (below 50) and the lowest print since March 2009.
Every component was weaker, including new orders and employment.
That's not helpful.
You might have woken up this morning and checked U.S. stock futures. You might have noticed they were down roughly 1.5 percent and wondered, "What happened between the close yesterday and overnight that made futures go down 1.5 percent?"
The answer is, not much. There have been no big headlines. Just a few small ones that, collectively, have added up.
Some traders have pointed to a new report from the Asian Development Bank (ADB) that lowered Asian growth forecasts for 2015 and 2016 on softer prospects for India and China.
The ADB now sees GDP for China at 6.8 percent in 2015, down from 7.2 percent earlier. India is projected to grow 7.4 percent, down from an earlier 7.8 percent forecast earlier.
Read MoreADB slices Asia growth forecasts
There was the usual discussion of the knock-on effects of slower China growth on Southeast Asia, as well as soft global commodity prices which puts pressure on Asian commodity-focused export economies like Mongolia, Indonesia, Azerbaijan, and Kazakhstan.
Still, stocks in China ended up fractionally.
European markets opened down modestly and have drifted steadily lower. The dollar is modestly higher, but commodities like copper also began trading lower overnight and have also drifted lower through the morning.
Why are stocks down today? There are several reasons:
1) This is a quadruple witching expiration, the quarterly expiration of stock index futures and options, and individual stock futures and options, with large volume and volatility at the open and close;
2) Oil is down almost 4 percent, a proxy for global growth;
3) The Federal Reserve has sent a message to investors: it is more concerned about global growth than it had let on.
Let's focus on the Fed for a moment. The central bank clearly stated it was concerned about the state of the global economy and its impact on the U.S. Bank of America/Merrill Lynch summed it up Friday morning: "The Fed acknowledged our concerns for global weakness, and this acknowledgement is a bearish signal for risk assets."
Now that the Federal Reserve has made its decision—for better or worse—it's time to turn to what really matters: 1) the state of the U.S. economy, 2) the state of the rest of the world, and the impact this has for corporate revenues and earnings.
To the extent that the Fed lowered its expectations for growth, that is certainly a negative sign for earnings.
And earnings and revenues could use some help. The second half of the year was supposed to see an improvement over the first half's flat earnings growth, and negative revenue growth. Not happening.
Here's the current Q3 estimates from FactSet:
Earnings: -4.4 percent
Revenue: -2.9 percent
Much of this disappointment is due to energy, where earnings are expected to again be down a stunning 65 percent. That's not a typo—65 percent. If you remove energy, the S&P earnings would be positive 3.1 percent, revenues would be positive 2.7 percent.
Well. That was something. Even though the Fed did not move, they did surprise.
Did the Fed just introduce a third mandate?
This is the sentence that had everyone talking: "Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term."
This is a remarkable statement.
Fed Chair Janet Yellen repeated this again during her press conference, specifically calling out slowing growth in the Chinese economy as a factor in their decision and noting the future risk there of "a more abrupt slowdown than some analysts expect."
So the Fed's mandate is: 1) job creation, 2) control of inflation, and 3) everything else (global economic and financial developments)?
Some will argue this is an exaggeration. The Fed is not introducing a third mandate, they are merely acknowledging the interconnection of the global economy. It's all appropriate, some will argue.
And there is certainly a practical consideration: the Fed may not want a stronger dollar, no matter what they say, because of the negative impact on corporate profits.
Having introduced the global economy as a factor in your decision-making, how do you turn this ship around? Do you not raise rates until the Shanghai stock index recovers? What's the criteria for that? Are we also now "data dependent" on Chinese GDP?
There's a real problem when the Fed starts acting as the global banker of last resort.
Trying to reduce the September Federal Open Market Committee meeting to game theory, the question becomes, "How do you win?"
Let's get one thing clear. A lot of traders have already won, and so the question becomes how to avoid losing. In the last five days, the S&P 500 is up 2.2 percent. A lot of traders have adopted a "sell the news" position. In other words, they either sold at the close Wednesday or will lighten up on the announcement, regardless of what the decision is.
I'm in the minority on this, but I believe the most likely scenario for the markets to rise still rests on the "one and done" scenario.
There's a lot of "ifs" here. If Yellen stumbles, if she fails to convince that the economy is strong enough, or implies another rate hike is imminent, the whole thing could fall apart. A muddled message would be a disaster.
Some of Tuesday's rally could likely be attributed to traders front-running a well-known Wall Street phenomenon: the tendency of stocks to rise in the 24-hour period before an Federal Open Market Committee announcement.
It's called "The Pre-FOMC Announcement Drift." Traders have been aware of this phenomenon for years, but the observation was given a research imprimatur in 2013 when David Lucca and Emanuel Moench, two officials with the Federal Reserve Bank of New York, published a paper on the phenomenon, noting that the move up was real and "orders of magnitude larger than those outside the 24-hour pre-FOMC window."
They not only said the phenomenon was real, they quantified it. Since 1994, the S&P 500 is up an average 0.49 percent in the 24 hours before an FOMC announcement.
Lucca and Moench not only noted this was an outsized return, they made an even more startling claim: the returns over those eight yearly FOMC meetings accounts for 80 percent of annual realized excess stock returns.
That got a lot of attention on trading desks.
Moreover, Lucca and Moench concluded that some other major foreign stock markets exhibit "similarly large and significant pre-FOMC returns" but that no similar effect in Treasuries was discerned.
Other macroeconomic news releases, such as the employment report, GDP and initial claims, also don't have the same effect on stocks.
Why does this effect exist? Lucca and Moench speculated that it may be a premium required by investors for bearing "non-diversifiable risk." That is, investors want more to hold stocks going into an uncertain policy announcement. However, they ultimately conclude that they aren't quite sure why the effect occurs and conclude that the drift remains "a puzzle."
Regardless, the phenomenon is certainly real, and we have even begun seeing attempts to jump ahead of the trend, which may explain a good part of yesterday's rally.
BioMed Realty Trust on Thursday announced that it agreed to be acquired by Blackstone in an all-cash deal valued at $8 billion.
U.S. Democratic presidential candidate Hillary Clinton will propose a tax on high-frequency trading, her campaign said.
Slowing global growth has been one of the predominant investing themes in 2015