Triptych of pain

Good news everyone!

There’s an alternate universe out there. And in it, the stockmarket is booming, price signals are valid, and statistics aren’t fake. Don’t take my word for it. Ask Stephen Hawking.

The resident genius of this our universe told a conference in Stockholm that you might actually be able to get from this universe to the next. You’d have to hitch a ride on the nearest black hole. More technically, he put it this way: “The existence of alternative histories with black holes suggests this [trading universes] might be possible… The hole would need to be large and if it was rotating it might have a passage to another universe. But you couldn’t come back to our universe. So although I’m keen on space flight, I’m not going to try that.”

It’s a little like the Hotel California, then, isn’t it? You can check out any time you like etc. Come to think of it, isn’t this exactly what a capital control is; a kind of Hotel California for your retirement? Your money is welcome to stay as long as it never leaves.

Speaking of China, what news from the East? Well, its stunning stockmarket collapse continues apace, although collateral damage being done around the world has abated. Stocks in Shanghai fell 7.6% again on Tuesday. They’re down 22% in the last four days.

I’ll come back to whether you can trust markets anymore and where money leaving China might flee. But first, take a look at the chart below. I made it myself. I’m calling it ‘Triptych of Pain’. I walk by the Tate Modern each day on the way to the office here at Friar’s Bridge Court. Perhaps an exhibit?

Even if the Tate declines to exhibit my work, you can see that it’s still evidence. But evidence of what? For one: quote stuffing.

Yesterday, I reduced to the algorithm-induced volatility in the markets. Your evidence is above. For example, yesterday alone, the Dow Jones turned a 442-point advance at the open to a 205-point decline by the close.

Now, it’s possible that a lot of investors are carefully reassessing their position after two shocking days – and then fleeing for their investment lives in terror (not a bad strategy). But it’s just as likely that the volatility in indices and stocks is an unexpected and unwelcome feature of a market floor dominated by computers and not human beings.

All hail our new drone overlords!

On the upside, you get massive synchronised capital movements into single stocks or asset classes. The herd moves all at once with monster truck force. A high volume of buy orders are ‘stuffed’ into order taking systems creating a digital melt-up. So far so good.

But on the downside? The quote-stuffing overawes the system with ‘sell’ orders. You get a proper crash. The only way to stop it is to stop the whole system. That brings me to Exhibit B in the case against the ‘fake market’, the exchange-traded fund (ETF) market.

Let me first say, I’m a big fan of exchange-traded funds, when it’s a bull market driven by liquidity. I first wrote about them in 2004 in my book, The Bull Hunter. Aside from trying to be clever, my point was that the emergence of ETFs would bring new liquidity to previously isolated classes and make them ‘investable’ to retail investors and fund managers.

The best example at the time was the gold ETF. It made it easier to ‘own’ gold for people who don’t even know (or care) what gold’s atomic number is on the periodic table (it’s 79). ETFs brought share market liquidity to commodities like oil and gold, to emerging market assets (funds would buy the underlying shares in an index to create the ETF), and even bonds.

ETFs ‘financialised’ the commodity markets in a powerful way, positive at first, negative lately. They’ve also essentially reduced nearly every investment idea to a single, often ‘optionable’ security. You can go long volatility (Vix call options), shore the energy sector with two times leverage, or long the ringgit with a series of phone calls.

By the way, I’m not recommending you do any of those things. I’m just pointing out that it’s never been easier for an individual investor to turn an idea or an inkling or a hunch into an actual position that could quickly make (or more likely lose) you money. It’s no wonder financial product providers love them.

But the ease of use and appeal of ETFs disguised a potential problem that’s been exposed this week. It’s a distant echo of the ‘portfolio insurance’ aspect of the 1987 crisis. A feature that was designed to make things safer and easier for investors turned out to be a bug. That bug is a flaw in the system. Today’s Wall Street Journal explains:

Products built to provide insurance for investors came up short. As a result of trading halts in futures tied to the S&P 500 index, it was difficult for investors to get consistent prices on contracts linked to them that offer insurance against S&P 500 declines.

Circuit breakers, which are designed to pause trading in single stocks and ETFs during big moves, were triggered nearly 1,300 times Monday. The circuit breakers were added to make markets more orderly after the May 2010 “flash crash,” when the Dow Jones Industrial Average dropped nearly 1,000 points before quickly recovering. 

But Monday, they sometimes exacerbated problems by preventing prices from returning to normal levels quickly, according to traders, investors and market observers. 

For example, the $2.5 billion Vanguard Consumer Staples Index ETF and the $5.8 billion Vanguard Health Care Index ETF both plunged 32% within the opening minutes of trading. The Vanguard Consumer Staples ETF was halted six times over the course of 37 minutes early in the day, according to trading records. The health-care ETF was halted eight times Monday. 

The declines in these and other ETFs were notable in that they exceeded the declines in the prices of their underlying holdings. In the case of the Vanguard Consumer Staples ETF, the value of the underlying holdings in the fund fell only 9%, according to FactSet. 

The giant swings in the market and problems with ETFs pointed to a need to rethink rules governing stock trading, analysts said.

Abnormal pricing.

Dysfunctional markets.

Insurance products not working properly.

Are you beginning to sense a theme?

As I said yesterday, you’ve been given a rare peek behind the proverbial curtain. There is no wizard. Click your heels while you can or suffer the consequences of staying inside the system.

But if you’re not keen to move to Kansas and begin prepping for the total collapse of the financial system, think of the cash. Your cash. You might want to do something with it while it’s still mobile and free to cross borders (or exit banks).

If you want another peek behind the curtain to see what happens when capital is in crisis, keep your eye on China. A 22% decline in stocks in four days is a proper crash. Chapeau!

You have to give the Chinese credit. Their adoption of Western-style capitalism comes complete with jaw-dropping financial panics. Of course, I jest.

Capitalism and free markets are dead everywhere now, especially China. The whole thing is an illusion.

Yesterday the People’s Bank of China cut reserve requirements for banks. It was an attempt to inject about $100bn of liquidity into the financial system. Or, in metaphorical terms, it was an attempt to make the illusion seem real; the illusion that everything is normal and fine.

Just last month China’s Ministry of Finance gave the nation’s largest pension fund permission to buy stocks. The £350bn fund is allowed to invest up to 30% of its assets in equities. The obvious and rhetorical question is: could the timing have been any worse.

But you go to war with the army you have. And China needs to fill up the stockmarket with new money faster than the old money can leave it. It’s like lining up fresh recruits and sending them out of the trenches and ‘over the line’ into the capital conflict.

Both moves – the extra liquidity and the pension fund trying to meet future obligations by putting money into the stock market – are designed to reassure people the stockmarket crash is completely unrelated to the economy, which is, of course, functioning, healthy and growing. In tandem, perhaps they will arrest or slow down the flight of capital from the country.

Everything’s fine. You got that? Nothing to see here. Move along. But keep your money stationary.

“Liquidity conditions are still under immense pressure”, said Société Générale’s Wei Yao. Last week’s Yuan devaluation accelerated capital flight out of China. When that money leaves, it has the effect of tightening liquidity across the economy.

As Richard Duncan pointed out yesterday, the global economy – especially China’s – needs debt to grow. Capital flight and poor liquidity are the enemies of credit growth. Credit must grow at all costs. To save the economy, it may be necessary to destroy the currency.

If none of this makes rational sense to you, don’t be worried. What you’re seeing is a kind of peak globalisation; the natural limit to the growth of a world order based on debt. The collapse of that order will accelerate as politicians try to preserve the illusion that they can command the economy to grow at will.

Britain, by the way, is not immune to the illusion. Capital flight is a risk here, too. And in some ways, the illusions are even more powerful here than elsewhere. Everywhere you look, the country seems rich. But is it?

Category: Economics