Sunday, November 21, 2010

It's all the same to me

Once upon a time, investing in the stock market involved choices, selections, discrimination. Buying a stock was like planning a vacation.

That was then. Now, it's all the same to me.

Now stock selection is Fast Money. And Lightening Rounds of Mad Money.

Now all markets are linked tighter than the threads in fine hotel-count sheets. Liquidity, and liquidity alone matters. The rising tide of liquidity has unloosed tsunami-defined market movements. Tsunamis are, after all, just liquidity events.

Now, it is a rather quaint idea to buy "a" stock. The stock pickers gave way to mutual funds, which gave way to WTF ETFs, and all of them are bound up in aggravating algorithms, whose main purpose is to make sure money runs with the pack.

Jason Zweig writes The Intelligent Investor every Saturday for The Wall Street Journal. A couple of his recent columns touch on this development.

Are ETFs a Menace—or Just Misunderstood?
A report released this week produced by researchers at the Kauffman Foundation, the Kansas City, Mo.-based institute that supports research on entrepreneurship, argues that ETFs are "radically changing the markets," raising the prospect of a "panic-driven market meltdown." ETFs are funds that hold all the securities in an index and themselves trade like a stock.

The proliferation of ETFs, the report contends, raises at least three worries. First, these funds have overconcentrated the ownership of thinly traded stocks. Second, they have led to an escalating number of trading failures. Third, ETFs could trigger another massive market swing like the May 6 "flash crash."

Let's start with concentration. According to the report, a single ETF, the iShares Russell 2000 Index Fund, is among the 10 largest holders of 1,737 stocks—many of which also are held by other iShares ETFs.

Yet ETFs aren't traditional mutual funds. At an ETF, the manager's job isn't to make judgments on single stocks, but merely to keep the portfolio as close to its index as possible. And, in contrast to a mutual fund, "no one stock represents a large portion of the typical ETF," says Gus Sauter, chief investment officer at Vanguard Group.

Since ETFs must buy the stocks in the index they track, regardless of price, it is legitimate to wonder whether values aren't getting out of whack as ETFs come to dominate the market.

Why Your Stock Portfolio Is Acting Like a Commodity Basket
In the past few years, many investors have concluded that commodities like oil, corn and gold offer independent returns that can diversify away the risks of stocks. But the correlations between stocks and commodities—the extent to which their prices move together—are in many cases the highest they have been in nearly 30 years.

This year, about 40% of the weekly movements in the S&P 500 index can be explained by weekly fluctuations in energy prices, says Michele Gambera, head of quantitative analysis at UBS Global Asset Management. That is twice the level of similarity over the past five years and roughly 20 times the level of the past two decades.

Some of the linkages between stocks and commodities are looking bizarre. This Thursday, the monthly correlation between sugar futures and the S&P 500 hit 67%, more than 10 times its level just six days earlier, says Howard Simons, strategist at Bianco Research. That is the third time this year that the linkage between sugar and stock prices surged above 60%—much higher than their long-term average of under 20%.

How on earth did sugar and stock prices get stuck together? Sugar, says Mr. Simons, is now both an "energy commodity" and a "growth story," since much of the Brazilian crop is used to produce ethanol. That gasoline additive is linked to crude-oil prices, which in turn are sensitive to monetary policy and global economic growth—the same factors driving stock prices.

Of course, correlation isn't causation; this could be a coincidence.

But there is another, less visible force at work, Mr. Simons says. Algorithmic trading programs, or "algos," automatically buy and sell a wide variety of assets based on mathematical models.

An algo doesn't know or care why two assets are moving together; it merely is programmed to recognize that they are doing so. As soon as a computer places bets that such a linkage in prices will persist, other traders—computers and humans alike—tend to take note and follow suit. That can be true, Mr. Simons says, whether or not a correlation is driven by fundamental economic factors.

"We've gotten to the Frankenstein point where algos are self-programming, and they evolve to chase these relationships," Mr. Simons says. "That's created a sheer wall of money that is forcing other people's behavior into the same pattern."

What's more, quantitative easing—the massive purchase of bonds by the Federal Reserve—and the global recovery have been bullish for just about every asset. But at past economic turning points, the correlation between stocks and commodities were lower than they are today.

For the foreseeable future, there will be plenty of periods in which diversification will seem to fail as tidal waves of money crash in and out of all assets at once.

As Guambat wrote back in 2006, just as stock markets began to go parabolic and then alcoholic,
A black box is not some fatcat in a pin-striped suit and a big cigar. It is a streak of cyberdata, a stateless, motherless virus hellbent to ambush, arbitrage and retreat faster than a ninja.

And they are everywhere, in to everything. Their bytes permeate every conceivable market, like a monstrous whale seiving the nutirients and little, bottom-of-the-food-chain investors and small players from the oceans of cash that trade the world's goods.

They derive their gains from diverse derivatives of incalculable numbers and varieties, trading the shadows of what used to be a currency or a commodity or a stock or a bond, but now come under the most obtuse and arcane of names that only financial rocket scientists can understand. Their trade is in ideas and concepts and notions and algorithms, not things and companies.

Back when stock picking became more treacherous, due in no small part to the huge and creative gaps in GAAP reporting, Enron accounting and Swiss bank/tax haven black holes, Guambat gave up stock picking and took up nose picking. Didn't make any more money, but didn't lose any, either.

Then, for reasons not really very well rationalized, Guambat got into trading the Australian stock market futures contract. It went well for a short while, but around about the time he wrote the words quoted above, he began to be overwhelmed with market moves that utterly made no sense to him, as tsunamis often take us by surprise.

So he's been beached for a while now, and with the regular tides now turning into a series of tsunamis, with tsunami sized ebbs and flows, he has no desire to go back in the water. It's just too treacherous, too rigged, and plays by games too fantastically contrived to offer the likes of Guambat any latitude for entertainment, let alone success.

If Las Vegas treated its gamblers the same way the stock markets now treat the casual punter, it would be in worse shape than it already is. Markets are simply a no-go zone for hobby traders any more.

If Wall Street wants to entice the likes of Guambat back to its markets, its going to have to build a better sandbox, and leave the concrete mixers to the big guys.

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