Wednesday, August 31, 2011


This late into a rally and deeper into an economic cycle, second-derivative news ("better than expected") can be tricky, as it usually doesn't move the market's needle.

Be forewarned amid the cheerleading over the past three trading days. (Again, interest rates (lower) and gold prices (higher) are usually warning signs.)

Here are some intelligent comments on the likelihood of QE3 from economist Rich Farr at Boenning & Scattergood:

Yesterday, on CNBC, Chicago Fed President, Charles Evans, said that the Federal Reserve may need to be even more accommodative unless the economy shows significant improvement. Also yesterday, Minneapolis Fed President Narayana Kocherlakota signaled he may be open to dropping his opposition to further easing policies.

OUR CONCLUSION: The Fed can’t possibly believe that QE2 helped the economy. The evidence is overwhelming that QE2 did more harm than good. We’ve argued all along that if $600 Billion in QE2 can be proven mathematically to have worked, then why not do $600 Trillion? If it works, then we should be doing it in incredibly large scale so that we all become wealthy beyond our wildest dreams.

Despite the fireworks over the last few days, the continued drop in interest rates and the ramp in gold are significant warning signs that I am now paying attention to.

Some sensible talk and excellent perspective from Miller Tabak's Peter Boockvar this morning:

After weak mfr'g data in the regions of Philly, NY, Richmond, Dallas and Kansas City, the Chicago PMI fell to the lowest since Nov '09 at 56.5, down from 58.8 in July, but was above expectations of 53.3. New Orders fell 2.5 pts to 56.9 and Backlogs were down by almost 6 pts to below 50 at 49.6. Inventories fell a touch. Employment rose .6 to 52.1, off the lowest since Dec '09 in July. Prices Paid moderated by 3 pts to the lowest since Oct. Chicago PMI has historically been influenced by the auto sector and production has come back well after the disruptions caused by the Japanese disaster. This may be a factor in the better than expected print. All that matters now though is the ISM national figure that will merge all the regional figures but today's Chicago number not as bad as feared may help the ISM to stay above 50. Expectations are currently 48.5.

Over the course of financial history, the U.S. stock market has served as a conduit and repository for investors and savers. It is the platform upon which new capital is raised for start-ups, for emerging companies and for existing businesses. As such, equity markets assist and are invaluable in the creation of jobs in our country and, in turn, in promoting aggregate economic growth.

But the toxic combination of price momentum-based high-frequency trading strategies and the proliferation of leveraged ETFs has served to launch the newest forms of financial weapons of mass destruction, and they're alienating legions of investors.

Computers don't sleep, don't get tired, don't care about politics or fundamentals and don't vacation in late August in the Hamptons or on the Jersey Shore -- they just wreak havoc on our marketplace by amplifying moves on the upside and on the downside.

The de-risking in the hedge fund industry and a record level of domestic equity mutual fund liquidations have reduced the role of the more stable classes of intermediate- to longer-term retail and institutional investors. The ensuing vacuum created has produced heightened volatility and an unforecastable risk-on/risk-off atmosphere owing to the increased presence and disproportionate role of high-frequency, momentum-based trading strategies and intraday adjustments to the holdings of leveraged ETFs. (Some have estimated that high-frequency trading now accounts for almost 75% of all trading!)

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.

These financial weapons of mass destruction have taken over the wheel in a period in which there is already too much uncertainty about the economic and stock market future. These strategies and vehicles have no redeeming social and/or economic value. Indeed, one can argue that their influence (on the market's volatility) is contributing to the negative feedback loop that is threatening our domestic economy's growth trajectory.

One only has to look at the intraday price movement between 3 and 4 p.m. EDT during yesterday afternoon's trading session to understand the damage in investor confidence that is being done to our marketplace -- up more than 10 points on the S&P 500 from 3 to 3:30 and then back down a like amount in the last half hour of trading -- by the randomness and unpredictability of stock movement caused by the two factors.

I want to quantify the dimension of the loss of confidence on the part of the individual investor.

In June nearly $21 billion was redeemed from domestic equity funds. Last month, almost $29 billion was redeemed and, in August, it has been estimated that more than $35 billion poured out.

The $85 billion of outflows from June to August will likely approach the previous three-month record of $88 billion, which came out of domestic equity funds between September and November of 2008!

Thus far in 2011, individual investors have sold about $75 billion of domestic equity funds, only $10 billion less than last year's total outflows.

Astonishingly, since the beginning of 2007, domestic equity mutual funds have had net outflows of more than $400 billion (in the same period, $835 billion of fixed-income funds have been purchased! That spread between stock outflows and bond inflows -- $1.235 trillion -- is unprecedented in the annals of financial history.

I fully recognize that the instability and damage to confidence caused by the impact of high-frequency trading strategies and uber-leveraged ETFs are not the sole reason for retail disenchantment with stocks. A weak jobs picture (with about 9% unemployed and another 9% working part time or just giving up on a job search), stagnating real incomes (and screwflation), broader economic uncertainty and the ever-present memory of the 2008-09 investment and economic shock are additional reasons individual investors have developed a distaste for stocks.

Nevertheless, time is running out to stop the damage in investor confidence.

If these financial weapons of mass destruction are allowed to continue to impact our marketplace -- as they did again on Tuesday -- investor confidence will not be restored for years.