Consciousness of Sheep
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The US stock market experienced its biggest ever points fall on Friday; and prices continued to fall around the world as exchanges opened on Monday morning. The story no doubt sold a lot of financial newspapers and sent a few policy makers into a tail spin. But in percentage terms there was nothing extraordinary about the sell-off. It is precisely what markets used to do week-in, week-out in the days before central banks started propping up markets with low interest rates and quantitative easing (QE).
In part, the declines over the weekend were the result of growing fears that the Federal Reserve Bank is about to end its QE programme and hike interest rates back to at least three percent (the margin that they believe they would have to cut in order to stave off another crash). There is, however, a darker side to what happened.
First, and most obviously, the trading environment has changed dramatically since 2008. Far fewer shares are traded. This is because listed companies have been using cheap currency to buy back their own shares.
Shares are issued as a means of raising capital for new investment. And just like a loan, they pay interest in the form of a dividend to shareholders. But if, as has been the case since 2008, there is no incentive to invest, it makes little sense for a company to keep paying dividends. Just as you or I might pay off a credit card debt as soon as possible to avoid unnecessary interest, so companies buy back their own shares to avoid unnecessary dividends. The practice, however, is often driven by greed rather than common sense. Corporate CEO remuneration packages are often tied to the value of the company shares. Managers can raise their pay simply by using corporate borrowing (at low interest) to buy back shares, even if this leaves the corporation dangerously exposed to interest rate rises later on. There is an unforeseen consequence to the practice too. With fewer shares being traded, institutional investors like pension and insurance funds are obliged to compete for what is left; thereby driving share prices far higher than they ought reasonably to be.
Second, since 2008 we have shifted from active to passive trading. Rather than pay a skilled (some would say merely lucky) human to sit in front of a screen buying and selling shares all day, we have turned over most trading to automated computer programmes (algorithms) which are mostly designed to follow the herd. That is, if shares rise, they will buy them and if shares fall they will sell. It is this automation that has previously resulted in so-called “flash crashes” in which so many algorithms are trying to sell that prices temporarily fall to zero. When this happens, stock exchanges have to do the equivalent of hitting Ctrl-Alt-Del; shut down the exchange and wait hours or even days for the system to reset.
Third – this is where it gets murky – armed with this knowledge, it is much easier for some of the relatively few humans still engaged in trading to take advantage through a process known as “running the stops” or “stop hunting.” For the most part, this is simply the means by which some traders have always made money in a bear market. It is just that low volumes and algorithmic trading exaggerate the gains. To insure against losses and to protect gains, investors will use “stops” – in effect, orders to sell the stock if its price falls below a certain point. Stop orders, however, are not a guarantee that the stock will be sold at that price; they are merely an instruction to try to sell.
In normal trading, stops are triggered all the time. If, however, a price crash can be engineered or exacerbated, it is possible to buy automated trades at a much lower price. Suppose, for example, a stock has risen rapidly from $50 to $100. Some investors might have stops at $95, more at $80 and lots at $60. In a market dip – like the one that started on Friday – a human might calculate that the stock was actually worth more than $100. But by selling off their own stock, they can quickly trigger the $95 stops. At that point, the algorithms will attempt to find buyers at that price; but with the market falling few, if any, buyers will be found. The result is that the price will slump to $80; triggering the next round of stops with more or less the same result. The price crashes through $60, and rapidly back to $50. At this point, the human trader reverses position and begins buying; harvesting most if not all of the stock with higher priced stops. Stock prices soon settle, markets rise, and the algorithmic investors have lost their income while the human traders have doubled their profits.
What happened this weekend is no doubt some mix of all three of these factors. And while we may be reasonably angry about the way already rich Wall Street institutions can shake down ordinary investors in this way, in the long run it is the action of the Federal Reserve and the other major central banks that is more alarming. If the markets are this jittery about a likely 0.25% increase in the overnight lending rate, what does this tell us about the health (or rather sickness) of the underlying economy?
High streets in the USA and the UK are currently being decimated as a result of lower currency values, rising commodity prices and higher interest charges. The proportion of the population with savings has collapsed while the number of bankruptcies is soaring. Changes in household spending patterns have caused big layoffs in the retail sector; and despite media hopium about the growth of online sales, these account for just a small fraction of the losses.
In one sense, what happened over the weekend was a test of the Federal Reserve’s resolve. Would they ride to the rescue or would they let the market crash? The answer, as we discovered on Friday afternoon, was that – for now at least – they are going to ride to the rescue. On Friday they pumped a huge amount of newly printed currency into the US Treasury Bond market – reversing one of the less obvious declines that triggered the stock market fall. Then, on Monday, they began buying shares; contributing to the stabilisation and eventual rise in share prices.
The big question for all of us, however, is whether they are going to continue to unwind QE and to raise interest rates. If they do, they risk triggering another depression and a much bigger collapse in share prices. But what happens if they blink? What if they announce that the economic data is weakening and that interest rate rises will be put on hold and QE will continue?
The answer is in the Bond market and the value of the dollar. Both are already falling. And while less government borrowing and a less valuable currency is great for exports… if you are China; for net importers like the USA and the UK, it spells unsustainable price increases. It also means higher interest rates as governments are obliged to pay more to borrow the money they need to operate public services and to pay pensions and social security.
In short, the US (and UK) economies are now caught between a rock and a hard place. The vulnerability was briefly exposed by the fall in share prices over the weekend. But this was merely a harbinger of a much bigger storm brewing on the horizon. It is remarkable that by bailing out bankrupt banks in 2008, and propping up markets ever since, the central banks have kept the party going for a decade. The hangover, however, is going to be a bad one. Everything that was too big to fail in 2008 is likely to be too big to save next time around.
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