Monday, August 22, 2011


Buybacks are not silver bullets unless a corporation is buying back stock well under its private market value. Even with this metric, there should be some margin of error, especially during these uncertain times.

HPQ repurchased about $7.5 billion of stock at an average price of over $38 a share in 2010. Over the last seven years, the company has bought back over $60 billion of stock at an average price of $37 a share.

Today's equity capitalization of Hewlett-Packard? Only $50 billion.

Enough said.

The growing ambiguity of worldwide economic growth, a negative feedback loop engendered by the political circus in Washington, D.C., and signs of an increasingly fragile European banking industry have (in large part) contributed to the recent selloff in the world’s markets. I am convinced, however, that several noneconomic, temporary and artificial influences have conspired to accelerate the recent drop of stock prices.

A General De-risking by Hedge Funds

The recent selling bout has occurred at a time when, according to the ISI Hedge Survey, hedge funds were already reducing their net equity exposure. ISI’s latest numbers (based on “the actual exposures at 35 funds capturing $86 billion in long/short assets”) indicate that net hedge fund exposure has moved to about 45.8% -- that’s the lowest exposure in two years. Hedge funds have cut back based on growing losses (and the trading associated with the discipline of limiting losses) as well as in response to the marked rise in the VIX, which creates a higher VAR (dollar value at risk per day). The swiftness and magnitude of the drop has begotten more and more selling by the hedge fund community.

Recent Hedge Fund Redemptions

Large redemption requests in the hedge fund community have led to further selling pressure. Many of those hedge funds had a large exposure in the financial sector, and this could explain the outsized drop in bank stocks and other non-bank financials.

A Nearly Unprecedented Liquidation of Domestic Equity Funds

Last month, individual investors fled equity funds in a massive move toward the flight-to-safety trade. In July, over $25 billion was redeemed. A week ago, over $20 billion was pulled. Surprisingly, assets were taken out of every mutual fund asset class (equities, taxable and nontaxable bond funds) and went into money market funds. I estimate that individual investors will pull out at least $35 billion in August, representing the second-highest liquidation on record since the series of data began to be accumulated in 1979. It is almost a certainty that 2011 will represent the fifth consecutive year of liquidations -- something that has never happened in mutual fund history.

Combined with the taking away of the original uptick rule, I think the high-frequency trading is a major negative for the stock market. It is a major negative for the economy, and it does not do anything for the economy. It does not add any value to the economy. It doesn't add any social value. Charles Munger, Warren Buffett's partner, in an interview on CNN in May, essentially said the same thing.

These high-frequency traders begin the day owning nothing and end the day owning nothing in terms of common stocks. During the day, they are accounting between 50% and 60% of the volume.

There was a terrific article in The Wall Street Journal on Tuesday. The headline was “A Wild Ride to Profits.” The article talked about what happened on Aug. 8, when the S&P 500 index was down 6.8%. That day happened to be the single most profitable day in the history of high-frequency trading. These high frequency traders made an estimated $65 million. While on that day, the stock market lost $850 billion of value....

The liquidity that they add to is useless liquidity. It has no lasting value. It consists of orders that are placed and that are quickly retracted. It heavily, heavily consists of front-running.

It is amazing to me the New York Stock Exchange puts up a facility right next door to their computers in New Jersey and then they lease out space to 10 or 15 or 20 of the highest so-called co-locations so that those individuals putting their computers there can get a microsecond of an advantage over their competition. If the New York Stock Exchange thinks this is a smart idea, in order to generate volume, I don't think so.

But can I go back to something else? There was no high-frequency trading four years ago. What permitted high-frequency trading, in my opinion, to occur was when the SEC removed the uptick rule -- on July 7, I think, 2007.

Right now, I ask a question, where are the regulatory bodies? We have had a major destruction in confidence. You can help restore confidence to the markets tremendously, in my opinion. If the SEC would consider reinstating the uptick rule, reinstating the uptick rule -- if you reinstate the uptick rule, you don't have to do anything else. That will bring high-frequency trading to a screeching halt, but understand that the New York Stock Exchange may not be in favor of it. The major investment banking firms won't be in favor of it. The hedge funds, most of them, won't be in favor of it.

-- Marvin Schwartz (Neuberger Berman) on CNBC’s “Strategy Session” (Aug. 18, 2011)

The influence of these factors has been to produce a dearth and vacuum of normal retail and institutional trading flows and activity. The absence in the marketplace of these more stable classes of intermediate- to long-term investors has brought on heightened volatility, producing a perfect storm of selling as the increased presence and disproportionate role of high-frequency, momentum-based trading strategies has exacerbated both the up and (mostly the more common) down moves during the month of August.

This unfortunate set of affairs has, in essence, transformed a relatively stable marketplace into a casino-like environment, as investors have been replaced by machines that trade securities not based on intrinsic value decisions but on small trading edges and price-momentum-based algorithms.

The bad news is that the SEC is remarkably unresponsive and apparently unaware of the damage being wrought by the quants and by the kings of high-frequency trading during these difficult times for most investors. The good news is that it is likely that the hedge fund de-risking and mutual fund redemptions are growing mature, might be materially behind us and will probably slow in influence in the period ahead.