Wednesday, March 10, 2010

What Do Baseballs, Gravity & Program Trading Have In Common?

This post is intended to provide you with a deeper understanding of where I think our markets are going, how we got here, and why. I concluded my previous post with the question: "How should we model our current and future markets? Should we base them on previously proven market making strategies or should we venture into the unknown/unproven (algo/program) territory?

First, lets compare our current and past markets bullishness.One argue in years past bullishness was supported by a fundamentally strong market/economy correct?... Well then our current similarly bullish trending market MUST be supported by fundamentals! No problems here! If you are saying to yourself, "This guy is nuts, our current market is nothing like the past!", you are in the right mindset to continue reading.. Though much to your dismay I am not nuts!

My brief thesis is as follows:
I believe the current speed of communication combined with the proliferation of electronically correlated markets have created a unrealized/unproven medium for gov/banks to simulate a healthy market via trading trickery regardless of where true market fundamentals reside. 

In past buying the buying of fundamentally strong markets was rationalized, warranted and encouraged because the economy *appeared intact and growing. During these markets, dips were bought, fresh retail money gushed, thus was no need for "intervention" as we trended for 15 years until 1999-2000. Then 9 years of wild gyrations commenced, which turned out to be the markets way of informing the street the house was burning(still burning IMO). The (still) burning house which took 9 years of smoldering to ignite now has "crashed" "bottomed" and "almost recovered" in one year. CNBC would say; "Crazy, This is a record recovery!" Well, not really considering we are in an age which information is delivered instantly and a few key players control the entire market ebb/flow via ETF's and free money(TARP/SLPs).

The few key players I mentioned above(we are all very aware of them) "thought up" a way to ramp our markets via trading trickery. "Thought up" meaning: Once the major banks realized there was a natural liquidity vacuum that was not going to plug itself, they devised a way to put our markets on life support.

*The easiest way to jump start a heart is a shot of adrenalin, the markets needed a shot of adrenalin after 2008. The markets syringe was filled with cash, injected directly via preferred share purchases and the creation of Supplementary Liquidity Providers. It was widely known major banks "pre 2008 crash" had been working with algorithms and HFT trading, though "pre cash injection" banks did not have the adequate ammo, regulatory head nod and or a real reason to release the unproven programs in full scale. Post crash & cash injection it was a different story. Once the banks concluded the best way to revive our markets was to put the new found piles of cash to work in the market via HFT and algorithmic program trading.This was only possible after the banks received a regulatory under the breath "go ahead". The programs were released in full scale around Dec 2008 and have not been scaled back since. Now that all the firms know the "trading trick" they have by chance or design engineered a very focused and highly coordinated "recovery" which completely ignores the absolutely garbage/depressing fundamentals. The programs have created a market which naturally falls at any given moment until the programs step in "throwing" the market back into the air.

None of this would have been possible if not for the recent IT advances in trading technology. Now that the technology is readily available, our markets are now 100% running on what was intended to be temporary "life support". At some point the programs will run out of money and the markets will then search for natural bids, *If any exist. The following analogy might help you better visualize how these programs are indeed keeping the markets from seizing up.

Think back to when you were a kid tossing a baseball onto the roof of your house/garage. Remember how hard it was to, first predict where the ball would roll off and second to catch the ball ounce it erratically popped off the gutter? Think about doing this for a year without dropping the ball once. It is not possible right? Now replace the baseball with "the index(s)" and your glove/arm with "life support programs", when the programs ramp us hard the index(s) are being thrown back onto the roof. As the index(s) trickle back with gravity they approach the edge of the gutter, (or support) the index(s) reacts unpredictably before plunging towards the "life support programs"(glove). Since they are so fast, their gloves are always in place to catch the ball. The program then throws the ball back up onto the roof.. and repeat, repeat. Sometimes the ball(index) gets a bit closer to the ground causing the programs to scramble around the driveway wildly, though the ball is always eventually scaught.

Until we can throw the ball over the roof effectively putting an end to the cycle we are playing with fire betting against gravity. Eventually what goes up and is not securely held in place with permanence (FUNDAMENTALS) must come down. So are we on our way to 20 more years of up trending? Probably not. The markets need a real catalyst that will naturally keep the ball from rolling back off the roof, the life support programs created by banks are simply playing pitch and catch with only one participant, it can only last so long before the fun is over.

In closing i will leave you with an alternative theory explaining why our current markets are they way they are: Basic economics 101 tells us it is possible with enough capital and knowledge of the market to cause distortion in perceived real "demand" thereby cornering a market *artificially driving the price higher. Or for those who did not sit through Dr. Self's Econ 101; "to purchase enough of a particular stock, commodity, or other asset to allow the price to be manipulated", much like crude traders the past year(s). Could this be what is happening to our markets on a huge scale? Perhaps the "true demand" or market price(s) remains drastically lower? If this is the true what will happen when the manipulator is outed, or exits the market? Am i saying this is happening, not exactly, though I do believe massive collusion is possible if enough parties are "in the know".
The most boring yet most widely believed explanation i have for you is: The buying could just be systematic "price discovery" programs pushing the index(s) up to resistance levels to reveal if fresh buying will follow. Either way, if we keep going up why not ride it....Only time will tell.

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