Working on the Knight moves

By now, most everyone is familiar with the story of Knight Capital Group.  Basically, an algo went bonkers, a bunch of stocks got roiled at the open, and Knight lost $440 million.  Over the weekend, Knight found a white knight to infuse it with capital in a highly dilutive convertible preferred sale.

Today, TheTradersWire.com, in conjunction with Nanex, posted a great piece on exactly what happened on that fateful morning.  As you read the Traderswire post, do yourself a favor and click through to the Nanex link.  As usual, Nanex provides pictures of the mess that are worth a thousand words.  Or $440 million.

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Clowns to the Left of Me, Jokers to the Right

We frequently blog about the structural strains put on the market by algorithmic and high frequency trading.  We’ve also blogged (more than a few times) about the distortions in price discovery caused by central bank intervention, zero interest rate policy, etc. (most recently pointing out that 80% of the annual equity premium since 1994 was attributable to trading in the 24 hours before a Fed announcement).

This morning, however, saw a convergence of the two we seldom get to “enjoy.”

First, today’s episode of “Algos Gone Wild” was set at the NYSE, where 148 symbols began trading wildly and with ludicrous volumes at the open.  While there seems to be some linkage to Knight Capital, the specifics are not yet clear.  What we do know is that these stocks started swinging inexplicably by magnitudes of 10% or more.

A quote from a director of floor trading:  “Stocks are moving all over the place, they are weird, and they are trading like millions of shares 100 shares at a time.”

An example, provided by CNBC, would be Molycorp.  This stock traded 5.7 million shares in the first 45 minutes of trading.  Typically, Molycorp trades about 2.65 million shares per day.

If there is an upside to this story, the NYSE quickly halting the affected stocks may very well have averted another flash crash.  Small consolation in the scheme of things.

While the algo drama was unfolding, Louis Bacon put out a letter regarding his multi-billion dollar Moore Global Investments fund.  Bacon is voluntarily returning $2 billion to his investors, for the following reasons:

  • “The markets have been riskier and less liquid.”
  • “Markets are increasingly distorted by central banks’ attempts to squeeze drops of growth from an over-indebted private sector across much of the developed world.”
  • The US markets are hindered by “a caustic political environment and an anti-business administration.”
  • “The [Eurozone] banking authorities have been a special case in ineptitude, [waiting to raise bank capital] until it is largely infeasible.”
  • “Disaster Economics, where assets are valued based on their ability to withstand a lurking disaster as opposed to what they may yield or earn, is now the prism through which investors are pricing markets.”

Pretty strong words from the 238th richest American and uber-successful hedge fund manager since 1987.

To get some sense of how prevalent the Louis Bacon-type behavior has become in the hedge fund industry, Google “hedge funds calling it quits.”  Bring a cup of coffee, because you’ll be spending a lot of time reading your computer screen.

These are indeed weird times.  Navigating them requires extreme care in both capital allocation decisions and sizing of positions.

To paraphrase the 1972 song by Stealers Wheel:  “Fed to the left of me, algos to the right.  Here I am stuck in the middle.”

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Random Thoughts and Observations

  • Bill Clinton is officially “off the ranch.”  First, he announces that the Bush-era tax cuts should be extended.  Then, during his apology for the aforementioned comment, he noted that median family income is now lower than it was when he was President.  I never thought I’d miss Bubba, but his candor is kind of endearing.  Never mind his hanging out with porn stars in a Monaco casino.  I REALLY wish I could get this guy to come to a poker game at my house next weekend!

  • France lowered its retirement age for public employees from 62 to 60.  Really?  As your continent financially sinks into the sea, you tack on  a larger fiscal burden?  Granted, Hollande kept his campaign promise, but at some point Germany is going to tire of being slapped in the face by the French man-glove.  A quick read of Der Spieigel will give you some idea as to how soon that fatigue may set in.  I’ll give a clue…  next week.  Fetchez La Vache!
  • This week was the best week for the stock market in 2012.  The 285 point jump on rumors of Fed easing mid-week set the stage for the best week of the year.  Short covering continued through Friday.  I can’t blame the shorts for covering.  Watch for a hyped up European can-kicking announcement this weekend.  Those who are short US Treasuries and long European banks will likely have a nice day on Monday.  Two months from now those trades may not look so great.  But money managers are judged monthly, so many will live or die based on the rumour du jour.  Such is the world in which we live.
  • Despite the Drudge Report’s best investigating, nobody ate any new faces this week.  Time to go long faces and short Drudge, which has become shallow and pedantic.
  • Our President came out today and declared the domestic economy to be “doing fine.”  It may be, for those attending $40, 000 per plate parties at Sarah Jessica Parker’s house.  My anecdotal observations might provide evidence to the contrary.  But I’m loathe to get political on the blog.  I just wonder what he may be smoking.  Maybe the Choom Wagon made a stop in DC  this week.
  • UBS apparently lost $350 million as one of their traders on the Facebook IPO kept hitting the left mouse button over and over assuming his buy orders weren’t being filled since he wasn’t getting timely trade confirmations from NASDAQ.  He ended up owning 40 million shares.  Turns out he bought them at $42 then sold them at $30.  You can’t fix stupid.  Or bullsh*t.  Take your pick.  So, UBS is suing NASDAQ.  The great litigious American tradition.  I assume a “settlement” is in the making.   It shouldn’t, but does, yield a giant yawn.  Lose on your bet, get it back on your lawsuit.

Have a wonderful weekend, folks.

If it were hockey we’d call it a Facewash. In IPO’s it’s called a Zuckerpunch.

The Facebook launch on Friday was much like that of a North Korean missile – much hyperbole, much cheerleading, displays of excited citizens crowding the public square, a launch…  then a thud.

At this point, I have no interest in in opining on Facebook’s pricing, revenue persistence, market penetration, or all that fundamental stuff.  Rather, I thought it may be interesting to point out some of the oddities that occurred during the day of the Taepodong-2… I mean, Facebook launch.

Let’s start with the opening.  Slated to launch at 11:00, the first trade was delayed until 11:20.  While Nasdaq is playing the role of Korean Rocket Scientist today, Telis Demos from Trading Technology wrote a nice piece on the cause of the delay.  Here are a few quotes from the article (although I encourage you to read it in its entirety by clicking the link):

“And it was one quote cancellation sneaking into a five-millisecond window that caused about 20 painful minutes, watched live by the world on CNBC television, of the delay to the opening Facebook’s public offering on Nasdaq’s US market.”

“In brief, the problem was that the system took two extra milliseconds to calculate the opening price. Because of a decision before to allow continuous order placement during IPOs, cancellations kept “fitting in between the raindrops”, in the words of Bob Greifeld, Nasdaq’s chief executive, in the five milliseconds it was taking to determine a price.”

“As a result, Nasdaq had to manually override the process, which took up those 20 minutes. But the manual process meant that individual order confirmations were not sent out until almost 1.50pm, hours after the 11.30am opening print. Confusion reigned, and many blamed it for dampening demand for Facebook stock.”

I’m no rocket scientist myself, but this sure looks like the fingerprints of high frequency trading.  Sneaking a big order cancellation in a five millisecond window would have been impossible for a human being – even the late, great Benevolent Dictator with all his superhuman skills.

The next oddity is brought to us by Nanex Research.  Again, I suggest you visit their site for some great graphic illustration, but I’ll summarize a few of the conclusions here:

  • Between 11:54 a.m. and 1:50 p.m. Nasdaq quotes stopped coming through the conventional channels.  To quote Nanex, “Those who are co-located and get the direct feeds, namely HFT’s, didn’t experience this problem, as trades continued to come from Nasdaq.”
  • At around 1:50 p.m., trades began mysteriously executing 120 milliseconds before the bids printed.  Nanex calls this “fantaseconds, ” or evidence that HFT’s may now be able to 1) trade faster than the speed of light, or 2) orders are being routed in an unconventional manner that may be outside of the regulations.
  • Later that same second (yes, as in 1/60 of one minute), trades were executed 900 milliseconds before the quotes were printed.
  • At the same time, there were stretches where Facebook trades accounted for 100% of all Nasdaq stock trades.

The final extreme characteristic of this launch was Morgan Stanley’s role in supporting the missile’s $38 price.  From Reuters:

  • “Morgan Stanley may have spent billions of dollars to support the stock price by buying shares in the market. Some market participants said that the underwriters had to absorb mountains of stock to defend the $38 level and keep the market from dipping below it.”
  • Morgan Stanley had access to 63 million shares in the over-allotment option, giving them plenty of ammo to hold the line at $38.
  • Reuters also points out:  “As an indication of the cost, had Morgan Stanley bought all of the shares traded around $38 in the final 20 minutes of the day, it would have spent nearly $2 billion.”  That’s a lot of cabbage, if the stink over JP Morgan’s trading loss is any indication.

I think the autopsy of this IPO in the coming weeks will prove to be both interesting and educational.  Has the HFT become self-aware and turned on its creator (Nasdaq)?  What new procedures will be in place to keep a debacle like this from happening on future IPO’s?  How much of a hit to capital will Morgan Stanley ultimately feel?

It’s rare that market sausage-making happens on a stage as large as the Facebook IPO.  Maybe that will help be a catalyst for better understanding our brave new trading world.

I Can’t Get No Satisfaction

I client asked me an interesting question last week.  After reviewing his monthly report, he simply asked, “Are you satisfied with your recent performance?”

It’s a short question, but one with a lot of built-in complexity.

Any period we lag a highly publicized index like the S&P 500 (whether or not it is a relevant benchmark) we ask this question of ourselves, so I found the question to be very relevant.  In hindsight, having more equity exposure would have produced better results in the intermediate term, so measured by that metric, I’d be foolish to be satisfied.  We would always like to capture gains when they are available to be captured.

The question, though, leads into a larger issue – which I suppose underlies the original question.

Should we have, in retrospect, changed our method of managing money to take advantage of a persistently rising stock market?

John Maynard Keynes had an interesting perspective on that question, as well as on those who manage money.  Their primary objective or “their first and last rule” as he put it, is to keep their jobs.  As Jeremy Grantham added, “To do this you must never, ever be wrong on your own.”  So, the great majority of advisers go with the flow, creating momentum that drives prices far above or far below fair value.  Grantham sites an interesting observation regarding the volatility of the stock market, GDP growth and the fair value for the stock market.  Two thirds of the time, annual GDP growth and the annual change in the fair value of the market is within +/- 1%.  The market’s actual price, courtesy of the herding mentality, is within a whopping +/- 19% two thirds of the time.  The rough conclusion:  The market moves 19 times more than is justified by the underlying engines.

Circling back to Keynes, he notes that a money manager who follows his long-term strategy “will be perceived as eccentric, unconventional and rash in the eyes of average opinion.  And if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”

So this is the trouble with money managers acting as agents.  They are consistently forced to weigh their career risk against their assessment of investment risk.  In today’s environment, avoiding career risk means accepting only two premises:  First, there is no need to add alpha; you simply have to leverage beta.  In English, that means you don’t need to bring skill to the game, you only need to apply leverage to the market in order to beat the market.  Second, the only thing in the world that matters is liquidity. As long as liquidity is being provided, stocks will go up.  Evidence of these premises in practice is easy enough to find.  Presently, mutual funds are levering beta at the historical level of 1.1.  As for liquidity, it’s easy to find charts showing stocks rising during periods of quantitative easing and immediately retreating when the spigot has been turned off.

Our mindset differs from that of many advisers in that we are (and invest as) principals, not agents.  Without being flippant, I don’t spend much time worrying about career risk.  I accept that there will be periods of time we under-perform the herd or a stock index, and at those times we may be perceived as “unconventional.” When this happens we may not receive much of Keynes’ mercy.  Incidentally, we don’t spend much time expecting mercy either.  That’s why we keep our investments as liquid as is practical – capital is free to move in or out at the discretion and personal judgment of the investor.

Given the increasing risks we see in the global financial markets, we will not be increasing our risk profile at this time.  We are convinced that risk is being underpriced.  We believe that behavioral issues, rather than rational issues, are driving stock prices.  I’ll spend some time addressing those risks in my next blog post, but it is our intention to maintain low betas, seek ways of adding alpha, and keeping a fair amount of powder dry so we may apply systemic hedges to the portfolio when or if our macro outlook comes to pass.

Back to the original question… in terms of our investment returns aligning with our objectives, I’d have to say we’ve done what we set out to do.  We are asked by our investors to deliver consistent returns in a risk averse way and our portfolios continue to be invested to reflect that objective.  And over various stretches of time, doing that isn’t particularly satisfying.