GalaTime

Themis Trading: Toxic Equity Trading Order Flow on Wall Street

What Is The Effect of All This Toxic Trading?

1. Volume has exploded, particularly in NYSE stocks. But you can’t look at NYSE volume on the NYSE. The NYSE only executes 25% of the volume in NYSE stocks … traders Magazine estimates high frequency traders may account for more than half the volume on all U.S. market centers.

2. The number of quote changes has exploded. The reason is high frequency traders searching for hidden liquidity … this has significantly raised the bar for all firms on Wall Street to invest in the computers, storage and routing to handle all the message traffic.

3. NYSE specialists no longer provide price stability. With the advent NYSE Hybrid, specialist market share has dropped from 80% to 25%.

4. Volatility has skyrocketed. The markets’ average daily price swing year to date is about 4% versus 1% last year.

5. High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.

Excellent read. And the controversy around intellectual property related to quant funds continues: The Cold War in high frequency trading turns hot

From an intraday low of ~ 2250 in October 2008 to a high of 4450 early this morning. Double in 7 months. Go figure.

Sigma Rising: The Junk Rally and Quant Hedge Fund Underperformance: a Lesson in Asymmetric Risk

Given the current market environment, the risk of an equity portfolio is similar to the risk of a book of options with large gamma.

Large positive gamma means that the value of equity increases at a quickly increasing rate as the value of the firm’s assets increases. Reinterpreted in the context of an equity risk model, we can say that stock Beta and specific risk will increase at an increasing rate as the firm experiences positive asset returns (and vice versa for negative returns).

The above two observations can explain the explosive returns observed in banking stocks during the recent rally. According to the theory, observing these type of explosive upside returns is more probable than ever given that banks have witnessed unprecedented volatility in banking assets, coupled with the fact that most banking stocks are very close to being at-the-money.

It’s not uncommon for quant funds to be short the very firms that have the highest gamma and long the firms that have the lowest gamma. While many of these portfolios appear to be factor neutral, the embedded gamma causes these portfolios to become quickly unhinged.

Managing portfolio risk by only looking at portfolio standard deviation (or tracking error) is a recipe for disaster.

• Bloomberg: Bill Miller Not Dead Yet as Value Funds Bury Quants

Investors using so-called quantitative momentum strategies — which speculate that the worst stocks in the past 12 months will continue to decline — have become this year’s biggest losers after banks and companies that rely on consumer spending surged. Quant momentum techniques may have lost 27 percent this month in the U.S., the most since at least 1993.

While momentum investors have suffered in 2009, last year’s worst performers, Miller’s Legg Mason Value Trust and Harry Lange of the Fidelity Magellan Fund, are making comebacks with bets on technology companies. Both lost more client money than 98 percent of their rivals in 2008 by clinging to or doubling down on shares of financials. Now, Miller is outperforming 68 percent of his peers with a 1.2 percent gain in 2009 after boosting his stake in Hopkinton, Massachusetts-based EMC Corp. in the fourth quarter.

• WSJ: Why Capital Structure Matters

With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged, two-year rates of return approaching 100%.

Just as in the 1974 recession, investment-grade companies have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations are now raising capital through new issues of equity, debt and convertibles. This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations with strong capital structures started acquiring others.

• Hussman Funds: Trading Volume Separates Bull Markets from Bear Rallies

If March 6th proves to be the bottom of the market, Anatomy of the Bear author Russell Napier can put off his next edition for awhile because the most recent bear market won’t qualify as a great bottom. That’s because even though the market’s decline since 2007 has been one of the largest on record, it didn’t bring the market to truly great values. In his analysis of the stock market bottoms of 1921, 1932, 1949, and 1982 Mr. Napier chose to use two measures to gauge the valuation of the market. One was Robert Shiller’s PE ratio based on trailing earnings. As I noted in Market Valuations During U.S. Recessions , this ratio has fallen to the mid-single digits during periods of extreme undervalution. It’s currently 15. The second valuation tool Mr. Napier used was the q-ratio, a measure of market valuation relative to the replacement cost of assets. Deep undervaluation for this measure tends to be when market prices are roughly 35 percent of replacement costs. According to the most recent data the q ratio is about twice that.

An important observation that Mr. Napier makes in his studies of the most damaging bear markets is that even if the initial move off of the bottom is lacking volume, once a new higher level is reached, the market should begin to attract buying interest. In each of the bottoms he studied, volume expanded noticeably after the intial rally. This idea also holds up for the majority of bear-market bottoms. In the graph below the axes are the same as the graph immediately above. The vertical axis shows the percent change in the S&P 500 while the horizontal axis shows the percent change in volume. But this time the period is 6 months from each bear-market bottom.

• Alpha Magazine: The Power of Six (Masterminds of D. E. Shaw & Co.)

In a series of recent interviews, these six executives — managing directors Anne Dinning, Julius Gaudio, Louis Salkind, Stuart Steckler, Max Stone and Eric Wepsic — have given Alpha an unprecedented look at the people and processes that lie behind the company’s success.

“David, like [Caxton Associates founder] Bruce Kovner, approaches the business from a risk management perspective — you may not know how to make money at times, but you had better know how not to lose it,” explains Paloma’s Sussman, whose funds were down only 3 percent last year. “And that’s a very critical difference between what they do and what most people in this business do. First they decide how to size positions and how much risk they can take based on projections. The difference between the people who survive for long periods of time and have good records and those who don’t is risk management.”

Long - must read - piece.

• WSJ: Venture Capital Under Attack

America has now gone two straight quarters without a venture-backed company completing an IPO - the first time that’s happened since we started keeping records in the 1970s.

The second most pressing problem facing VC is pension funds, endowments and other buy-side investors running out of patience with small growing companies. Historically, buy-siders have understood and accepted that most economic value isn’t created until five years after a company’s IPO. But now, a focus on unfavorable current EBITDA multiples is displacing long term predictors of success such as market size, growth rate, technology and management experience.Finally, we have counterproductive regulations such as Sarbanes-Oxley, and could see two more regulatory measures that will end up undermining the already tenuous value proposition for venture capitalists and their limited partners.

• Morgan Stanley: Ready to Cope with the New Global Environment?

Just as during 2005-07 when strong positive global factors supported India’s growth above its then-sustainable growth trend, negative global factors are now pulling its growth below potential. Apart from adverse global factors, India faces the payback from the excesses of its own credit cycle and unusually high level of fiscal deficit.

Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India witnessed an unusually low real interest rate environment right at the time when its fiscal policy had been loose, as reflected in rising public debt to GDP. The key to lower-than-warranted real interest rates was the large capital inflows. Almost 85.6% of the total US$207 billion capital flows that India received over the four years ending March 2008 were in the form of non-FDI flows. However, in the era of global deleveraging and significantly lower capital inflows, the high level of deficit issue should remain in the form of higher real interest rates for the private sector.

• Hindu: Some exchange traded funds out of sync with Nifty!

UTI Mutual Fund’s exchange-traded fund - UTI Sunder and Quantum Fund’s exchange-traded fund - QNifty both of which are supposed to track S&P CNX Nifty and trade at close to one-tenth the value of Nifty have been moving out of sync with the index in recent trading sessions. UTI Sunder closed at Rs 440 and QNifty closed at Rs 351.05 on Thursday, both at significant premiums to Nifty which closed at 3358.50 (The most commonly traded ETF – Nifty BeES closed at Rs 337).

What’s going on? This is too big to call ‘tracking error’. Illiquidity + no arbitrage opportunity => Nonsensical prices!

• Zero Hedge: The Quants’ Role In Perpetuating Market Distortions

… vast systematic volumes of quant strategies in various time frames have become a destabilizing factor due to a convergence of strategies. In the end, the only way to win is to buy stocks that go up and sell stocks that go down and all strategies, no matter how many PhDs portfolio managers are involved, and so quants had to be in the same stocks, at the same time, swinging the market widely under their own weight. The bigger funds took the lead and the goal of smaller ones become to figure out what bigger guys will do the next day.

How is that any different from AAA CDOs constructed from sub-prime RMBS. Rating agencies made flawed assumptions, and now the prop risk managers allocating the bulk of the trading capital for the de jour hot quant manager, are making comparable mistakes, disguised as “assumptions” yet again. 

• Big Picture: US Dollar Index Since March 2008 Bottom
   

Isn’t it funny that mainstream media across the world has highlighted bearishness on the dollar since its bottom?

Two new sites for investors/traders in India:

MoneyVidya.com

MoneyVidya.com is a stock picking community for Indian investors, traders and stock market enthusiasts

On MoneyVidya.com you can:

• Discuss stocks, sectors and investment strategies with friends and top rated members
• Make stock picks and become a top member
• Find and profit from picks which match your personal investment style

Magic Formula Investing

Magic formula is a method of selecting stocks given by Joel Greenblat in his book titled “The Little Book That Beats The Market”. Mr. Greenblat argues that buying good businesses at bargain prices is the secret to making lots of money. If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr Market has decided to literally give away.

This website attempts to apply the Magic Formula Investing method to the Indian Stock Market.