The Deadly Market Sin - Complacency

The debate around the stock market’s performance continues to rage on. On one side the argument is that the market gains are justified because of explosive company earnings, Trump’s tax cuts or that the US markets are the only game in town. The competing view is that nothing has been fixed since 2007 and this is just all makeup on a pig. Low interest rates and company buybacks are fueling the drive for better returns. It is believed that it is all a slow motion train wreck ready to collapse. 

The purpose of this piece is not to add anything new to the debate but to highlight some issues that could arise in the event of the return of extreme volatility. Bear and Bull calls that appear initially correct could suddenly violently flip in a second as any number of unforseen events suddenly appear out of nowhere. Understanding historically how some of these events have been brought on may help dampen any future surprises.

The collapse of the Internet bubble, perhaps one of the largest financial fiascoes in U.S. history, came after a three-year period, starting in January 1997, when investors would buy almost anything even vaguely associated with the Internet, regardless of valuation. Investors ignored huge current company losses and were willing to pay 100 times expected earnings in fiscal 2002. They were provoked by bullish reports from sell-side securities analysts and market forecasts from IT research firms, such as IDC, Gartner and Forrester Research.

There are many of us who were around during the dot com bubble of 1999 to 2001 and lived the collapse of so many high flying overvalued stocks with huge cash burns and no profitability. The claim at the time was that it was a “new world.” Profitability did not matter. Eye balls mattered. As long as you had large traffic flows to your site you could worrry about profitability later.

All this activity did influence the economy and everything was firing on all cylinders. This held true for a while as long as investors kept throwing money at these wild west startups. The day the financing dried up, so did the company’s prospects of continuing as a going concern. The darlings of the day including pets.com, webvan.com, eToys.com, GeoCities, TheGlobe.com, go.com or flooz.com all but disappeared. This meant that these and thousands of companies like them ran out of cash and fired all their employees.  

Even if you are paying attention and think you understand the valuations you may be mistaken. The problem today is that companies and accountants are coming up with all kinds of clever ways to mask the true financial state of a company. This means that more and more professional and individual investors are not looking deeply enough into the details, as it takes more and more effort. Besides, it is not in reason to have to become an accounting forensic scientist just to figure out a company’s profitability. 

Jim Grant’s excellent “Current Yield Podcast” highlights the current environment of financial reporting in his show “Read the Footnotes,” and “Loan Sharks,” where for example they discuss how WeWork came up with different adjusted EBITA to suit their purpose. Fundamental analysis is usually how financial analysts make their judgements on a stock. If the company beats the analysts estimates it could rise considerably. If that analysis is flawed then the stocks are moving on false premises. Eventually stocks will always revert to their fundamental values, which indeed they did in 2001 to 2003.

What does this have to do with today’s market? A new report by the Wall Street Journal highlighted that a record number of IPOs, or 83% of US listed IPOs over the first three quarters of 2018, were companies that lost money in the 12 month prior to their going public. However, there are still many more that appear to have impressive balance sheets until their true financial state is exposed. Lurking within the financial statements and communications of public companies is a troubling trend. Alternative metrics, once used sparingly, have become increasingly ubiquitous and more detached from reality.

In 2011, Groupon Inc. announced plans for a highly anticipated initial public offering. But enthusiasm for the offering waned when the U.S. Securities and Exchange Commission (SEC) issued a comment letter questioning Groupon’s use of a profit metric it called “adjusted consolidated segment operating income.” It was believed that no company had ever used that metric before; it was intended to measure operating profit without including marketing expenses, stock-based compensation, and acquisition-related costs. Management argued that a $420 million loss from operations reported on its 2010 income statement should really be considered a $60 million gain.

The financial crisis of 2007-2008 that led to a decline in stocks was different. It began in 2007 with a crisis in the subprime mortgage market in the United States, fuelled by the Fed, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.

When this crisis hit and volatiliy exploded so did trading volumes. We remember trading on a few different plaftorms during this period only to see them seize up from the volumes daily. You could be correct on a trade but find yourself not able to get out. 

Then this showed up:

SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets

Commission Also Takes Steps to Increase Market Transparency and Liquidity

FOR IMMEDIATE RELEASE

2008-211

Washington, D.C., Sept. 19, 2008— The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The U.K. FSA took similar action yesterday.

They changed the rules of the game. A large number of traders were caught holding short positions in financial stocks having to scramble to get out of them. A massive short squeeze erupted. 

Just when investors and traders had positioned themselves for larger gains on the short side, the Fed stepped in with extraordinary monetary policy adjustments which included never before seen bailouts. Investors that never fully understood the old adage “don’t fight the Fed” paid dearly. 

Readers may be aware of some of these facts but it is essential to highlight that even though you may be correct in your trading or investment decisions and thesis, you are working with a dynamic system that has the leverage to change the rules to its advantage. Many of these adjustements could put the trader and investor at an extreme disadvange. We advise you to listen to the RealVision interview with Marc Cohodes as his experience with Goldman Sachs during this time illustrates this perfectly. 

In 1971 the New York Stock exchange incorporated as a non-profit. The change to for profit status was organizational and the result of a transaction first approved in April 2005 by the New York Stock Exchange governing board. In March 2006 the New York Stock Exchange, a non-profit corporation, merged with Archipelago Holdings, Inc. into a new organization NYSE Group, Inc. as a publicly traded and for-profit company.  In April 2007 the company in a stock swap transaction combined with Euronext, the European stock exchange, becoming NYSE Euronext.

Interestingly enough, we began to see the advent of high frequency trading. One of the ways exchanges such as the NYSE make money are by allowing big-deal firms to install their computers closer to the actual exchange, so their electronic trade requests will arrive milliseconds earlier than competitors. High frequency and algorithmic trading now accounts for a very large percentage of total exchange trading volume.

The May 6, 2010, Flash Crash, also known as the Crash of 2:45, the 2010 Flash Crash or simply the Flash Crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes. 

The Chief Economist of the Commodity Futures Trading Commission and several academic economists published a working paper containing a review and empirical analysis of trade data from the Flash Crash. They concluded the following:

“Based on our analysis, we believe that High Frequency Traders exhibit trading patterns inconsistent with the traditional definition of market making. Specifically, High Frequency Traders aggressively trade in the direction of price changes. This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses. Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders. Finally, when rebalancing their positions, High Frequency Traders may compete for liquidity and amplify price volatility.”

Traders and investors that still believe that we have free markets may get a rude awakening. Aside from the famous flash crash, we are still not able to forecast how these algorithm trading bots will react in the case of a market event or Black Swan. 

So as an investor or trader you may be holding a short position or long position and be correct in your analysis only to find the profitable company you have been invested in has just declared bankruptcy, or have your trading platform seizes up under the massive volume hitting the markets due to a shock to the market, rendering you helpless, have your brokers suddenly adjust all margins putting you at a severe disadvantage, have the Fed step in with a nuclear option not yet known, have the SEC ban short selling or suddenly watch in horror as prices tank as most of the market’s liquidity disappears because a number of large program trading algorithms have been turned off.

Complacency in these markets in any form can be deadly.