Market Crash

I recently received the following question from a friend of mine and wanted to share my thoughts with my market pals, and throw this out for feedback.  I would be particularly interested in hearing from my derivatives friends who are much more technically informed than I am on the subject.

“I was looking at something today that I thought you would probably have some comment on:  have you noticed how wide the out months on the VIX are versus the one or two month?  How are you interpreting this?”

From my viewpoint this has been a key debate/driver in the equity derivatives world for a good while now (I started having this discussion in early 2011 with some market pals and the situation has only grown more extreme since then).

In the past it has been the bond market whose vigilantes had rampaged across the fields to keep policymakers honest - but something has changed with the Fed's boot on the bond market. As BofAML notes, when the Fed was too soft on inflation or the fiscal deficit was out of control, interest rates spiked higher. In our view, this has changed and today the stock market is the disciplining force for Washington. We have argued this perspective for a while - that nothing will be done until we get a stock market crash - but the press will continue to make molehills out of mountains it seems as BofAML adds, the most obvious lesson of the last week is that when Washington approaches a policy impasse, the financial press tends to signal a resolution of the crisis many times before it happens. Don’t believe it. After elections there is always conciliatory talk: no one wants to be seen as a sore loser or a gloating winner. The risk remains huge and the four hurdles to a grand bargain seem to be getting larger - no matter what the press wants us to think - investors should look past reassuring rhetoric and focus on the underlying reality.

There was precious little in terms of actionable news in the overnight session, which means that, like a broken record, Europe falls back to contemplating its two main question marks: Greece and Spain, with the former once again making noises about the "inevitability" of receiving the Troika's long delayed €31.5 billion rescue tranche. The chief noise emitter was Italian Finance Minister Vittorio Grilli who said he was "confident that euro-region finance chiefs will reach an agreement on aiding Greece when they meet next week." He was joined by Luxembourg Finance Minister Frieden who also "saw" a Greek solution on November 20. Naturally, what the two thing is irrelevant: when it comes to funding cash flows, only Germany matters, everything else is noise, and so far Schauble has made it clear Germany has to vote on the final Troika report so Europe continues to be in stasis when it comes to its main talking point. In fundamental European news, there was once again nothing positive to report as Euro-area exports fell in September as the region’s economy slipped into a recession for the second time in four years. Exports declined a 1.1% from August, when they gained 3.3%. Imports dropped 2.7%. The trade surplus widened to 11.3 billion euros from a revised 8.9 billion euros in the previous month. Global trade, at whose nexus Europe has always been at the apex, continues to shrink rapidly. Elsewhere, geopolitical developments between Israel and Gaza have been muted with little to report, although this will hardly remain as is. Providing some news amusement is Japan, where the LDP opposition leader Shinzo Abe continues to threaten that he will make the BOJ a formal branch of the government and will impose 2% inflation targeting, which in turn explain the ongoing move in the USDJPY higher. This too will fade when laughter takes the place of stunned silence.

If the Fiscal Cliff negotiations are supposed to result in a bipartisan compromise, it is safe that the initial shots fired so far are about as extreme as can possibly be. As per our previous assessment of the status quo, with the GOP firmly against any tax hike, many were expecting the first olive branch to come from the generous victor - Barack Obama. Yet on the contrary, the WSJ reports, Obama's gambit will be to ask for double what the preliminary negotiations from the "debt deficit" summer of 2011 indicated would be the Democrats demand for tax revenue increase. To wit: "President Barack Obama will begin budget negotiations with congressional leaders Friday by calling for $1.6 trillion in additional tax revenue over the next decade, far more than Republicans are likely to accept and double the $800 billion discussed in talks with GOP leaders during the summer of 2011. Mr. Obama, in a meeting Tuesday with union leaders and other liberal activists, also pledged to hang tough in seeking tax increases on wealthy Americans." Granted, there was a tiny conciliation loophole still open, after he made no specific commitment to leave unscathed domestic programs such as Medicare, yet this is one program that the GOP will likely not find much solace in cutting. In other words, all the preliminary talk of one party being open to this or that, was, naturally, just that, with a whole lot of theatrics, politics and teleprompting thrown into the mix. The one hope is that the initial demands are so ludicrous on both sides, that some leeway may be seen as a victory by a given party's constituents. Yet that is unlikely: as we have noted on many occasions in the past, any compromise will result in swift condemnation in a congress that has never been as more polarized in history.

We expect a return to a skittish environment in markets. We are confident in my prediction for the course of the economy by leveraging simple game theory in handling the upcoming crisis as Congress returns for its lame duck session. “Compromise” reflects a decision from either side that each find unpalatable. Both President Obama and Speaker Boehner would rather shove two sticks in their eyes than move from their hardened stance despite some of the recent rhetoric in favor of bargaining in good faith.  As long as the loss of utility from both sides’ digging in their heels is more favorable than conceding to the preferences from those across the aisle, then the game arrives at a Prisoner’s Dilemma. the above matrix concludes that the fiscal cliff virtually guarantees an aggressive selloff for equities until the stop loss for the Democrats and Republicans has been triggered.  For example, if the clock hits midnight on New Year’s Eve with the blue chip index at or near its September peak, each faction would feel comfortable standing up to the other well into January.

A week ago we explained how, after completely destroying the equity and commodity space, and make serious inroads into bond trading (and soon very likely into OTC interest rate derivatives, where a flash crash will literally be the end), HFT algos had taken over FX trading to the point where they have now been caught manipulating the market using Reuters' FX trading platform. Now we get prima facie evidence of just how this destruction is manifesting itself. According to Reuters, which has compiled the data on its own FX dealing platforms, "daily spot foreign exchange trading volumes... fell by 23 percent in October from a year earlier. The average daily volume traded in October was $120 billion, down from $155 billion in October 2011 and a decrease from the $133 billion recorded in September." As to the reasons: they should be quite obvious. On one hand, we have the old tried and true vacuum tubes, and Reuters reports that the decline was to a major extent driven by "frustration with high-speed computer algorithms operating on the major dealing platforms." In other words, as more and more FX trading is merely robots competing with other robots to outarb each other on press releases, in the process completely crushing retail traders, and generating outsized kneejerk reactions to the tiniest of signals, any humans left are quietly shutting down their terminals and turning off the lights.

UPDATE: Minutes after we brought attention to this farce, VIX Futures and Options Re-Opened...

CBOE's VIX Futures and Options have been halted since 1337ET.

Because in our day and age of highly "sophisticated, precise and computerized" trading, just what stock market crash can take place without a critical component of the market breaking...

"Around the year 2005, a sudden spark will catalyze a Crisis mood. Remnants of the old social order will disintegrate. Political and economic trust will implode. Real hardship will beset the land, with severe distress that could involve questions of class, race, nation and empire." Strauss & Howe wrote these words in 1997. They understood the dynamics of how generations interact and how the mood of the country shifts every twenty or so years based upon the generational alignment that occurs as predictably as the turning of the seasons. The last generation that lived through the entire previous Crisis from 1929 through 1946 has virtually died off. For those who doubt generational theory and believe history is a linear path of human progress, I would point to the last week of chaos, disarray, government dysfunction, and misery of those who didn’t prepare for Superstorm Sandy, as a prelude to the worst of this Crisis. The lack of preparation by government officials and citizens, death, destruction, panic, anger, helplessness and realization of how fragile our system has become is a perfect analogy to our preparation for this Fourth Turning. The regeneracy of the nation will occur during the next presidential term. The mathematical impossibility of sustaining our economic system is absolute.

Back in the summer of 2010, when the SEC was still desperate to (laughably) scapegoat the May 6 Flash Crash on Waddell and Reed, in an attempt to telegraph to the public that it was in control of the HFT takeover of the stock market (an attempt which has since failed miserably as days in which there are no occult trading phenomena have become the outlier and have resulted in the wholesale dereliction of stock trading by retail investors), we first presented and endorsed the Nanex proposal that the flash crash was an "on demand" (either on purpose or by mistake) event, one which occurred as a result of massive quote stuffing which prevented regular way trading from occuring and resulting in a 1000 DJIA point plunge in minutes  (the audio track to which is still a must hear for anyone who harbor any doubt the market is "safe"). It turns out that in the nearly 3 years since that fateful market crash, not only has nothing been done to repair the market (ostensibly broken beyond repair and only another wholesale crash, this time without DKed trades, and bailed out banks, could possible do something to change the status quo) but the Denial of Service (DoS) attacks that HFT algos launch, for whatever reason, have become a daily occurrence as the following demonstrations from Nanex confirm beyond a shadow of a doubt.

Readers of Zero Hedge know well that one of the most abhorred (by us) accounting gimmicks employed by banks each and every quarter over the past 3 years to boost their bottom line, is to engage in loan-loss reserve releases: a process which has absolutely no associated cash flow benefit, but merely boosts EPS for GAAP purposes. In some cases, like this quarter's absolutely farcical JPM earnings release, the abuse is beyond the pale, as the offending bank releases reserves even as it reports surging non-performing loans: two processes which in a normal world can not coexist. Yet quarter after quarter banks keep on doing this, and in fact a big part of Q3's to date EPS outperformance is courtesy of financial company "earnings", of which, in turn, loan losses amount to about 50% of the entire blended financials bottom line. Yet while we can rage and warn, nothing usually happens until there is a market crash due to the gross manipulation of reality that such an activity entails. Luckily, this time someone with more clout in the legacy establishment has now stood up to warn about the mounting dangers associated with the relentless abuse of loan-loss reserve releases: none other than the US Comptroller of the Currency.

"The price action over the past few weeks in the wake of the markets getting more from the Fed than they could have ever expected heading into an election is a clue that the times indeed could be a changing. The 1987 paradigm underwent a similar period of choppy trade before melting down. Of course, crashes by their nature are a rare breed and the probability of one occurring is astronomically low. That said, should the S&P 500 fail to hold the 1400 level over the next few days (especially on a closing basis) we wouldn’t wait around too long in anticipation that the modern day version of LOR will save the day. The chart makes it clear that quantitative easing has diminishing returns. Soon they could be negative."

This past Friday, on the 25th anniversary of Black Monday, Bill Gross warned that in the current centrally-planned market "central bank puts" are the modern day equivalent of "portfolio insurance", and he is right. By sending complacency to record levels, and essentially forcing investors to no longer worry, hedge and generally ignore tail risk, the central planners, in their futile attempts to reflate stocks at all costs, are guaranteeing that the market will experience just the type of fat tail event they promise will never occur. As for the catalyst that will make sure of it is none other than our old friend: high frequency trading. Because while central planning is the mechanism by which investing is dragged away from mean reversion, price clearing and fair value discovery, it is HFT that is Bernanke's analogue in the millisecond trading world (as all those who had stop limit orders (that did not get DKed) on May 6, 2010 very well remember). Because when the next Black ___day does happen, it will be due to central planning, but it will be enacted courtesy of HFT (which will never go away until the next and probably final market crash: too much exchange revenue depends on the perpetuation of this parasitic liquidity drain). Which is why it is only appropriate to warn readers that when it comes to system market fragility, the frequency and magnitude of "wild price spike" events (to put it simply) are now both rising at an exponential rate, and fast approaching Flash Crash levels.

Caution is the word of the day.

Blowout quarter, or do US bank numbers just blow?

In April of 2009 we warned very explicitly that reliance on the fake "liquidity" (which was never liquidity per se but merely volume and churn) by the HFT algos that stuff quotes, frontrun each other, spoof, layer, and generally make a mockery out of the thing fomerly known as the market (which is now more than anything a policy vehicle for central planners but that's a different story) would result in tears. A year later the first flash crash happened, and ever since then more and more people have finally realized how our 3+ year long crusade against HFT (which sadly is now a minor distraction against the far greater evil which is central bank dominance of capital markets) was spot on, confirmed by the recent segments (here, here and here) on CNBC which effectively confirmed the markets are not only a joke, but without any real depth, i.e. fake. What is amusing is that people still don't understand why the exchanges, and the regulators (coopted by the exchanges) allow HFT to continue. Here is the answer: in 2011 the CME made 31.5% of all its revenues from HFT, the ICE: 25.1%, the NYSE: 21.4%, the Nasdaq: 17.1%, the CBOE: 22.4%, and so on.