Dear Friends,
We have said many times here over the past few years that the black boxes have captured the US financial markets. The lowly individual investor, the shareholders looking for value and a decent rate of return on their hard-earned investment capital, have become nothing less than chum for these sharks that operate with the full blessing of the government.
What else can you call a situation where transactions are completed in milliseconds and nearly the entire market cap of a publicly traded firm can be wiped out in 30 minutes by these “Machines Gone Wild”? What is a hard working citizen supposed to think when he comes home from work and learns that 10% or more of his entire net worth was wiped out in a single day?
This is no longer investing in any sense of the word – it is a gigantic feeding tank where the order flow from the public is the food that sustains an insatiable parasite that thrives by draining the vitality and substance out of its host, slowly killing it in the process.
I did not think Wall Street could sink any lower in the eyes of the investing public given the headlines of the last two years, but the following article from Bloomberg disabused me from that notion rather swiftly. What it details is almost mathematically impossible in the real world.
In a world in which markets are genuine, buyers and sellers meet to discover “value” in a given product when their decisions to buy or to sell taken collectively set a price upon a security that both groups are happy with on a given day. Sellers are pleased when they receive their asking price and buyers are pleased when they acquire a stock at the price they felt reflected its value on that day.
What makes markets interesting and so challenging is that no one knows in advance exactly where the “value” assigned by this collection of buyers and sellers will be on any given day. That is why good traders plan in advance a level or price at which they are willing to admit that their judgment of the “value” of a stock was wrong. If they are prudent, limit their losses and can maximize their winning trades, they will take 3 steps forward for every step backward. But the fact is even the best traders sometimes err.
Not so in the brave new world of the high frequency algo crowd. You see, they never have a plan for getting out of a trade that goes south because in the world in which they live, there exists no such thing. Up until now, I had believed that only God was omniscient (knows all things particularly in advance because He decrees them). Suddenly however, this new breed of mortals has achieved “godlike” status with perfect foreknowledge and flawless insight and can claim to stand on the same level with the Almighty in the realm of future knowledge.
Here is the truth – these huge firms have now become the market. It exists only to serve them.
Once upon a time, banks helped to create wealth by providing loans to build factories, start businesses and other creative enterprises. In the process of lending money, they received a fee and if they were thrifty and prudent managers of their customer’s wealth, they grew and prospered along with their customers as those businesses grew. Somewhere along the line, these behemoths lost sight of the role of a bank and have now morphed into giant black holes, that instead of creating wealth, suck it out of the pockets of the public engorging themselves like the hideous, loathsome tics that they have become.
Somehow I do not believe that this was what the Founding Fathers envisioned for our nation.
Trader Dan
Rigged-Market Theory Scores a Perfect Quarter: Jonathan Weil
Commentary by Jonathan Weil
May 13 (Bloomberg) — Score another triumph for the rigged- market theory.
In a feat that would seem to defy the odds, Goldman Sachs, JPMorgan Chase and Bank of America this week each said its trading desk made money every day of the first quarter. Goldman said its daily net trading revenue topped $100 million 35 times last quarter out of 63 trading days. JPMorgan and Bank of America disclosed similar eye-popping stats. Citigroup, too, recorded a profit on each trading day, Bloomberg News reported, citing unnamed people who knew the results.
The intrigue is high. If a too-big-to-fail bank’s traders were able to make money every day of a quarter, were they really trading in any normal sense of the word? Or would vacuuming be a more accurate term? What kinds of risks do such incredible profits entail, for the banks and the rest of us taxpayers? And are results such as these too good to be true?
There seems to be no satisfying way to answer those questions, or even the more basic inquiry: How exactly do these banks’ trading divisions make money? Reading the companies’ impenetrable financial reports is of little help. However they did it, the data suggest it was as easy last quarter as hitting the side of a barn with a baseball from three feet away.
This isn’t the way “trading” works in the real world. A simple exercise in measuring probabilities is instructive here.
Long Odds
Let’s say you manage a highly leveraged, diversified investment fund, and have become so skilled at playing the markets that you have a 70 percent probability of making money any given trading day. This would be a remarkable achievement in most markets. The odds that you would post a daily net gain 63 times in a row, though, would be about one in 5.7 billion. The formula for calculating this is: 1/(0.70 to the 63rd power).
Even if you had a 95 percent likelihood of a winning day, you would have only a 3.9 percent chance of doing it 63 trading sessions in a row.
Now consider that four of the biggest U.S. banks just pulled off a quarter-long win streak — all in the same quarter. Why would any of them even want to? Do they think the public doesn’t despise them enough? Surely it would have been easy to tweak the values of some illiquid “Level 3” assets lower for a day if they had been so inclined, just enough to avoid looking perfect. Yet none of them did.
These banks have the advantage of an unlevel playing field, of course. They can borrow money for next to nothing at current rates and lend it for more, simply by buying longer-term Treasuries. They have access to information that their clients lack. They have computer-trading platforms that operate in milliseconds. There’s less competition now that Lehman Brothers and Bear Stearns are gone. Yet even taken together, these factors don’t offer a satisfactory explanation for last quarter’s amazing streaks.
