Juggling Dynamite

I have been writing about the freakish trends in High Frequency Trading (HFT) for a couple of years now. As our markets have become ever more manipulated, Fed juiced, over-valued, under-regulated and pathetically under-policed, the HFT crowd has taken over. Over the past 5 years as risk-concerned individuals and institutions have pulled back from risk markets that are increasingly unattractive and precarious, transaction volume and traditional participants have fallen off precipitously. Like gardens left to run wild, markets have become overgrown with highly levered weeds and high frequency traders, who have come to account for 70-80% of all volume over the past couple of years. See my previous posts on this, including here where I point out the danger inherent in millions of computer generated trades moving 300 times faster than the eye can blink, only to be largely cancelled again before they are settled.  Sounds stable doesn’t it?

Just to show that we aren’t imagining the increase in HFT activity,  Mish brings us this animated GIF that chronicles the rise of the HFT Algo Machines from January 2007 through January 2012 by clicking on the link.   In this environment, traditional investors trying to use capital markets for rational activities are like old folks trying to hobble across a 6 lane autobahn with a cane at night, while the cops are on espresso break.

John Hussman, manager of Hussman Funds writes a weekly letter that I enjoy reading. John is a rare breed in the money management business: bright and highly educated, but also ethical, humble and incredibly disciplined, pragmatic and conscientious in efforts to protect the capital he has been entrusted with. His letter this week is quite a gem.

Over many years, I have found that John does a better job than most in tracking the leading indicators for the economic cycle as distinguished from the lagging and coincident indicators that many market commentators focus on. Here he is on Friday’s ‘surprise’ jobs gains (a coincident economic indicator) where seasonal and BLS adjustments changed an actual loss of 2.7 million jobs into a reported gain of 243,000 jobs:

“With regard to recession risks, the January employment report increases the divergence between leading evidence on the one on the one hand, where the broad set of data remains in a conformation that is almost exclusively associated with oncoming recession, and the more favorable, if lukewarm, signs from coincident indicators (e.g. employment, purchasing managers index, weekly unemployment claims) and lagging indicators (e.g. unemployment rate…

One of the great challenges of investing is the distinction between hindsight and foresight. Hindsight treats each major advance, each market crash, each recession and each expansion as if they’re turning points were obvious, and extrapolate prevailing trends as if their continuation is equally obvious. Foresight is much messier, because it deals with unknowns and unobservables. It recognizes that major financial and economic events are often hidden from view when they are actually already in motion. Foresight requires the willingness to rely on data that tends to precede important outcomes (recessions, market crashes, durable long-term returns), even when those outcomes can’t be observed in recent economic and market behavior that we can see and touch. Most importantly, hindsight creates the illusion that uncertainty is never very great, and risk management is never very challenging. Foresight demands a much greater appreciation for randomness, noise, uncertainty, risk management, and stress-testing.

Presently, there seems to be an unusually wide gap between hindsight and foresight, both in the financial markets and in the economy. In both cases, forward-looking evidence suggests weak outcomes, but recent trends encourage optimism and risk-taking.”

On the plethora of perpetually bullish stock analysts, Hussman offers this valuable insight:

“As a side note, the most frequent “valuation” approach that we hear from Wall Street analysts amounts to what we call “forward operating earnings times arbitrary multiple” and is embodied in statements like “we expect forward operating earnings next year to be so-and-so, and we’re also expecting a very modest increase in the multiple of about 2 points, which gives us a price target of such-and-such.” While this sounds reassuringly analytical and conservative, that particular model has almost always implied a one-year price gain of about 15-18%, regardless of the circumstances (you’ll find many analysts who projected just that even at the 2007 market peak). Valuation “targets” of this kind should not be taken as useful information, but instead as red flags.”

So true I giggled (cue images of Abbey Joseph Cohen and her many cohorts).  But in the end, the present mess of world markets is not really a laughing matter.  Risk assets today offer mostly intolerable risk for those of us who care about avoiding losses, and yet artificially suppressed interest rates and yields on defensive positions are painfully low. Here’s Hussman:

“Unfortunately, it is both dangerous to speculate, and utterly frustrating to remain defensive, in richly overvalued markets coupled with significant economic risks or strenuously overbought conditions.  This is the environment we are presented with, and it is in no way typical of “standard” market conditions, despite its repetition in recent years.”

No truer words! And still adults must do the right thing and stay defensive here, or suffer the consequences of more losses that are all but certain to follow for the masses yet again!  You can read his whole letter here.

There is much more to do before we get to a sustainable recovery, says Mohamed El-Erian Pimco CEO/co-chief investment officer, “it’s too early to declare victory”. Here is the direct link.