Revenge of the Squirrel Part Deux?

Trumbull Connecticut is a quaint little town.  It’s home to about 35, 000 folks who play in its wetlands, enjoy its stone bridges, and bask in the natural beauty abundant in the geography.  It’s an almost idyllic setting around the winter holidays – very Norman Rockwell.

Or so it would seem on the surface.

But Trumbull around the holidays is not all about caroling and wassail.  You see, Trumbull has squirrels – evil, conspiring, anti-Capitalist squirrels.

It’s December 9, 1987, 10:48 a.m.  Investors are still grappling the magnitude of October’s market crash and stock volumes are (back in those days) at historic highs.  Yet, thoughts are turning toward the welcome mental reprieve the holidays promise to bring.

Then it happened.

The NASDAQ went black.  Gone.  Vanished.

Call it mint jelly; it was on the lam.

For 82 excruciating minutes, the automated quote system went missing.  Over 20 million trades were stranded, as other markets felt the effects of the absence of pricing for OTC options.  For all intents and purposes the US stock markets were closed.

The local CT utility desperately tried to restore the juice, but an unintended power surge blew up the NASDAQ servers and crippled its backup generators.

By 12:05 p.m., a backup computer was placed online and trading slowly returned to the NASDAQ.  By the end of the day, normalcy had been more or less restored.

All that was left was the effort to find a cause.  After extensive forensic investigation it was determined the cause was…   a suicide squirrel.    It seems that a Trumbull squirrel, possibly mentally fragile and radicalized against the free markets (due to the rapidly rising costs of hickory nuts?), decided to do its impression of an under-amped fuse and closed a circuit that would have best been left open.

Fast forward to August 22, 2013, 12:09 p.m.  I was placing a trade to cover some calls we had shorted a month ago, when the call’s bid suddenly jumped from 13 cents to $998.00 (no, that’s not a typo).  The asking price stayed at 15 cents, only to disappear entirely moments later.  Confused, I cancelled my unexecuted trade and turned to the Bloomberg terminal to get a better sense of what was happening.  What came across the Bloomberg was surreal.  In less than a minute, 969 NASDAQ traded stocks were halted, citing “Extraordinary Market Activity.”  Specifically, it was called a “T6 Halt.”  From NASDAQ’s website, here is the definition of a T6 Halt:

Halt – Extraordinary Market Activity
Trading is halted when extraordinary market activity in the security is occurring; NASDAQ determines that such extraordinary market activity is likely to have a material effect on the market for that security; and 1) NASDAQ believes that such extraordinary market activity is caused by the misuse or malfunction of an electronic quotation, communication, reporting or execution system operated by or linked to NASDAQ; or 2) after consultation with either a national securities exchange trading the security on an unlisted trading privileges basis or a non-NASDAQ FINRA facility trading the security, NASDAQ believes such extraordinary market activity is caused by the misuse or malfunction of an electronic quotation, communication, reporting or execution system operated by or linked to such national securities exchange or non- NASDAQ FINRA facility.

The T6 Halt affected over 3, 000 stocks and countless OTC options.  What was most stunning; the problem wasn’t corrected for 3 hours and 19 minutes, making the 1987 outage pale by comparison.

Over half of the trading day was rendered inoperative.

While it is too soon to accurately attribute a cause to this halt (misuse, malfunction, hacking, an error in an AAPL trade, etc.), today’s experience served to make me just a little more cautious.  When the market re-opened, the NASDAQ surged to a 1.6% gain.  The other US indexes closed positive as well.

Intuition and experience might lead a person to believe that investor confidence would be reduced by a 3 hour 19 minute outage in the second largest stock exchange.  It would therefore follow that reduced confidence would be reflected in lower stock prices after the outage was resolved.

Alas, intuition and experience were wasted.

Having witnessed the collective yawn in response to what I (and many other professional investors) perceived as a frightening milestone event, I am led to one of two conclusions.

Conclusion 1:  The markets are now so thoroughly controlled by algorithmic and high frequency trading that experience and common sense have become archaic during periods of low trading volume.  Evidence of this can be seen in stocks like AAPL that immediately traded up to their VWAP once the market re-opened.  No change in fundamentals – just a return to VWAP.

Conclusion 2:  The sleeper cell of evil, anti-Capitalist squirrels has re-awakened.  Supporting this notion is the fact that I looked out at my bird feeder this evening and the usual collection of red and gray squirrels was conspicuously absent.  I’ll admit this data point is rather anecdotal, but 26 years ago we saw just what kind of damage a determined squirrel with an agenda can do.

Maybe Nassim Taleb would consider this a “Black Squirrel” event. – LL

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Of Hydrogen and Stupidity

It’s been said the two most common elements in the universe are hydrogen and stupidity; and stupidity has a longer half-life.  Not being a scientist, I’ll withhold comment on the 1937 zeppelin reducer.  Sitting in an office that plays CNBC all day, however, I can certainly attest to the widespread availability of stupidity.

This is the channel featuring pundit after pundit bleating out priceless nuggets like “at the end of the day, ” “fiscal cliff, ” and “wall of worry.”  If it weren’t for the cliché’s (and the constantly running ad in which a guy dramatically impales his eardrum with a Q-tip) the programming day would be about 90 minutes long.

But, during those 90 minutes, we’d be treated to some of the most repeated and inaccurate comments imaginable.  During the past few weeks, the topic du jour has been a listing of the reasons the market rally will continue.

 1.      “There is a ton of cash on the sidelines.”

This is commonly cited as a catalyst for increasing stock prices.  While there may be 2, 000 pounds of cash on the wrong side of the chalk line, its existence alone is… well… meaningless.  To make the point, follow this example:

Let’s assume that the entire stock market is made up of three people.  Here are their current holdings:

  • Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)

That means our market contains $901 in cash and 1 share AAPL.

Both Andy and Billy want to buy a share of AAPL.  Carl sells his share to the highest bidder, Billy, and collects $451.  Once the trade is completed, our investors hold the following positions:

  • Andy holds $450 in cash
  • Billy holds 1 share of Apple (AAPL)
  • Carl holds $451 in cash

$901 remains on the “sidelines” and 1 share of AAPL rounds out our market.

Look familiar?

There is an identical amount of cash on the sidelines after the transaction as there was before the transaction.  The only difference is that the holders of the sideline cash have changed.

What matters is not solely the amount of cash available for investment (with the exception of initial and secondary offerings), but the velocity in which the cash moves from person to person.  In other words, inflation in security prices is driven by the same factors that drive overall economic inflation:  

Money Supply x Velocity = Inflation

 As our national economy is illustrating so well, money supply can be increased indefinitely, but if velocity is zero, inflation is zero.  Stock prices are driven higher when a group of buyers look to increase the velocity of the cash they hold.  As velocity increases per unit of cash, prices inflate.

  2.      “Retail participation in the stock market is far below what it was in the 1990’s.”

While this statement is unquestionably accurate on its face, the implication that the participation deficit creates room for the markets to grow is misleading.  Here’s why:

  • Baby Boomers:  People born between 1946 and 1964 are typically defined as Baby Boomers.  In 1999, the oldest Boomers were 53 and the youngest were 35.  Arguably, this giant population bulge was smack-dab in the middle of the investment phase of their lives.  Presently, that population spans ages 49 to 67.  At that age demographic, particularly post-crisis, it is likely that the Boomer appetite for equities has diminished at least as much as their appetite for Big Macs.
  • Generation X:  people born during the 1960’s and 1970’s constitute this class.  Gen X arrived at the investment phase of their lives right between 2000 and 2010.  From January 2000 through January 2013, the stock market (S&P 500) has delivered a 0.15% annualized return with two major collapses (the worst being 52.6% peak to trough).  This is a generation that has never seen wealth accumulated via the stock market, yet they witnessed the near collapse of the global financial system.  Many lost their jobs as a consequence.    Convincing this generation that buying stocks is a good idea is a very tall task, indeed.
  • Pensions:  In the 1990’s, defined benefit pension plans were prolific – assuring a steady and predictable flow of cash into equity markets.  In the 20-odd years since, defined contribution plans (like 401(k)’s) have become a much larger share of the retirement savings market.  Participation in these plans is voluntary and the allocation to equities is up to the individual investor.    This problem is compounded with high unemployment and low participation rates constraining the number of plan participants.  Circling back to Gen X, it is unlikely we’ll see contribution levels like those that existed in the 1990’s.
  • Lower levels of personal wealth:  After the financial crisis and housing collapse, personal net worth in the aggregate has taken a massive hit.  And while the stock market has regained all of its 2007 – 2008 losses, it is unlikely that equity investors’ en masse held on through the bad years in order to fully participate in the recovery.  More likely, they sold out on the way down and failed to reinvest on the way back up.

 The evidence?

 There is a ton of cash on the sidelines.

  3.       “We are witnessing a rotation out of bonds and into stocks.”

This is the first derivative of “There is a ton of money on the sidelines.”  In the interest of time, I won’t go through the entire example, but here is how it sets up:

  •  Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)
  • Dave holds 1 Treasury Bond

No matter who sells what to whom else, the owners change but the market remains the same.

 

If I’m forced to hear these memes too many more times, I may very well impale my own eardrums…  if for only the sake of my sanity.

 

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