2012-09-19

The market is propped up by billions of fleas

People still refer to the May 2010 stock market crash as a flash crash and explain it away as algorithms gone bad. I believe the crash was real and it was the response to it that turned the market around. It wasn't a mistaken crash, it was a crash that was met with heavy buying. Now we have evidence of another market "flash crashing": the oil market.

Kilduff: Oil's 'Flash' Fall Is a Warning to All Markets
We have made the point that the actions by the Fed and the ECB are in response to a global economy that is floundering not flourishing. The equity and other markets have rallied due to all of the announced and expected easing measures, predicated on a belief that consumption and economic growth will necessarily follow due to extremely low interest rates and/or the positive effect of inflation on asset values.

Still, it was an odd epiphany that struck the energy market in a moment.

Prices seemed to collapse of their own weight, due to a buyer's strike. The demand outlook for next year has deteriorated markedly, and just this morning FedEx (FDX) has reduced its outlook for the all-important Holiday quarter.
Social mood is negative, but global central banks and global governments are pulling out all the stops to support the economy and financial markets. If at any moment, investors suddenly realize that things aren't going well, that the Federal Reserve and U.S. government aren't all powerful and can no longer prop up the markets, financial marktets could rapidly crash again.

The most important comment in the above: a buyer's strike. Over 70% of stock market volume is due to algorithmic trading, some of which have holding periods measured in milliseconds. Stocks are being supported by billions of micro-transactions. Micro-transactions usually refer to a trade of a small amount, but in this case I refer to a trade of extremely short duration.

Imagine a man holding up a heavy weight. He must use his own strength and he cannot lift too much, but he also can continue supporting this weight using only his own energy. He is the long-term investor who holds his position through thick and thin.

Now imagine a different scenario. Every 1 minute, another man comes and takes his place. Then 30 seconds later, then 5 seconds later, then 1 sec......each time the individual man's strength is less and less important, he only needs to hold the weight for a second. Then imagine that thousands of new men are supporting it every second, each man only needs to contribute a tiny amount of effort. In the abstract, we could imagine billions upon billions of fleas supporting a large weight, with each flea contributing a tiny amount. These are the high-frequency traders, who make millions of transactions per minute. Like a game of hot potato, stocks flutter from one buyer to another.

The energy expended to support the weight is the buyer's desire to hold a stock. A long-term investor who opens a position with the intent to hold for years and buy on the dips, has great desire for the stock. A high-frequency trader who wants to buy and sell the stock 100 times in one second has extremely little desire for the stock.

When more people want to buy (support the weight), the market is pushed higher, when the buyers dry up, it falls. In a healthy market, the long-term investors are the Atlas providing stability in the market. The fleas jumping around add liquidity and support the market.

Today, Atlas has shrugged. There is little long-term investor support in the market; the fleas dominate. They have grown into such a large swarm that no one has noticed Atlas left. But when the music stops, when the traders shut off their algorithms and the fleas disappear, there is nothing supporting asset prices and they rapidly collapse. Risk of extreme volatility has increased—whereas a bear market might have take several months to play out before, it now may only require a few hours.

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