Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Oops!
“Yesterday the bird of night did sit even at noonday upon the market place, hooting and shrieking.” - William Shakespeare, Julius Caesar
Sometimes the play doesn’t go like it was drawn up in the huddle. When the Greek debt crisis first raised its head back in January, the EU authorities assured the world that they would quickly find a solution, even warning people not to doubt their will. Fast forward four months to last Thursday, when European Central Bank (ECB) chairman Jean-Claude Trichet huffed about not being pushed around. He was promptly yellow-carded for delay of game.
That left the markets to sort out if Trichet’s zombie imitation meant that the EU still had no real plan. The sellers took charge, and the voting was not going the community’s way when the Euro started getting the drubbing of a lifetime in its weekly fixture against the yen. Yes, and in full color too, on screens around the world.
That sent some of the respective punters – rumor has it that they were massively leveraged – rushing to the local broker with sundry other securities to raise some cash. But around mid-afternoon, hello, the Dow takes the elevator shaft down about a thousand points and blue chip stocks are printing trades at a penny. Wait a minute, who drew up that play?
What happened? How can stocks like Accenture trade for a penny? At first the story was going around that it might have been a fouled order entry, in this case an attempt to sell $16 billion worth of futures rather than $16 million. That type of error has happened before, so it seemed plausible. But although it could explain why the market might drop a fast thousand points, it didn’t really explain how Accenture ticked at a cent per share.
A certain form of market order, called an “intermarket sweep order” (ISO), seems to have been partly responsible. ISOs are electronic orders that bypass the regular system in order to buy up or sell stock immediately at whatever market price is available on any exchange. It’s a way to execute an order very rapidly.
Now, if you were to look at a display of market makers in a busy Nasdaq stock, you would see a screen full of bidders on the left and sellers on the right. Look closely and you will see that the names at the top have the highest bid and sell prices. That is approximately where the stock is trading at the moment. Look more closely and you will see that the names at the bottom are offering to buy and sell at prices far away from the current market. That’s because they don’t have orders, but as market makers they have to put up a bid and ask. So they offer prices too far away to get taken.
You can see the same thing after the close in the stocks of the New York Stock Exchange (NYSE). Although the “aftermarket” technically runs until 8 PM, most stocks don’t trade much after hours. A few minutes or even a few seconds after 4 PM, the bid and ask prices may drop to something like a penny bid and a thousand dollars offered. In other words, the market maker is signaling that they’re not really trading in the stock anymore.
On Thursday afternoon, the market volatility caused the NYSE “circuit-breakers” to go into effect. These are trading restrictions designed to slow down trading, so the system doesn’t get overwhelmed by a cascade of automated orders (or a general panic). The circuit-breaker system originated after automated trading led to Black Monday in October 1987, when the markets suffered a 25% drop in a single day.
At this point on Thursday, some market makers effectively switched off their activity by doing things like dropping their bids to prices that were in effect non-operational. Since a minimum bid is only 100 shares, the sweep orders may have quickly taken them all out one after another right down to the bottom, where bids were sitting at the lowest possible price of one cent. Oops.
The NYSE and the Nasdaq markets weren’t slow to point the fingers at each other. We think it’s a safe bet that the blame is probably shared by the entire system, and an even better bet that nobody will take responsibility for it. Regulators will probably try to quickly implement some safeguards, but black boxes will soon try to find another way to game the system.
What’s the aftermath of the damage? The Greek crisis hasn’t gone away yet, and Trichet’s abysmal performance on Thursday (“nobody tells me what to do”) helped the budding fixed income fright get more traction. Such weeds are best nipped early on, but the government aristocrats of the EU mostly disdain the peasant financial markets. But as nobility has so often discovered, it’s time for a new dialogue when the angry mob shows up. Now they hope to have a statement ready by the time Asian markets open, so by the time you read this we should have an idea of its efficacy.
We’re not making any predictions on this one. Confidence builds over time, but it can vanish very quickly. We think that there is still time for the EU to get ahead of the crisis, but we remain constant in our diagnosis that in the end things will turn out badly. We just think it less likely to happen right away. Admittedly, that outlook didn’t look too perspicacious last week, but sometimes the politicians are dumber than you think they will be. Anybody remember Lehman Brothers?
The fixed income markets certainly do, and that has led to an unwelcome spike in interbank spreads and trading fear. The EU needs to virtually guarantee Greek paper as legal tender; anything short of that won’t work. If they can do that, then the crisis will rapidly dissipate.
By the fall, though, much of southern Europe may well be completely fed up with its new program of heavy austerity. The traditional return from the summer holidays in September is often a time of social unrest in Europe, especially if the economy hasn’t been going well. It’s hard to see how all the drastic cuts in spending are going to lead to prosperity in only four months, so it probably won’t be going well. That may be the time that Greece decides that the price for staying with the euro isn’t worth it.
Turning away from Greece, the markets are now down for the year. The Nasdaq and Russell indices plummeted over the last couple of weeks, losing about 10 and 12 percent respectively from their recent peaks. Past crises suggest that the market will be more volatile than usual for the next couple of weeks. There’s no official schedule for these things, but a look at the past record suggests that it typically takes one to three months for the market to regain its footing.
The economy has been improving, and that is to the good. The most immediate risk is that another credit freeze would lead to widespread order cancellation, as happened in the fourth quarter of 2008. Assuming we can get by that peril, and we certainly hope that it will turn out to be the case, then the next risk is that the rebound isn’t as robust as hoped.
So here’s the dilemma: if the markets can begin to work their way higher again by June, then the July earnings season will more likely than not disappoint the sense of heightened anticipation. Markets will sell off. But if a sentiment of gloom and doom weigh on prices until that time, then prices are apt to rally based on the outcome being not as bad as feared. Perverse, isn’t it? But as many realized quite suddenly last week, investing is never as simple as putting your money in and watching it go up.
The risk of getting whipsawed over the next couple of weeks remains. If you’re not dressed to play full-time, then we suggest you stay on the sidelines.
Let’s start with one of the most overlooked jobs reports ever. It might be fair to say that Thursday’s market glitch may have hijacked the Friday rally that we should have had, because the employment report was much better than anticipated.
The BLS estimated that payrolls were up by 290,000 in April, at the high end of the range and well above the consensus of 200,000. Not only that, but February and March were both revised sharply higher, with February gaining another 53,000 and March 68,000.
The bulk of the gains came in private industry, which is good, and even long-suffering sectors such as construction were finally in the black. Although the unemployment rate rose to 9.9%, it was due to people coming back into the work force and looking for work. It’s a typical feature of recoveries that when hiring finally starts to take hold, the unemployment rate will go up due to people becoming active seekers again.
There are still some problems: gains in earnings, average hours worked and the aggregate hours index were all quite weak. At least there’s no inflation on the horizon from labor. The U-6 rate (the percentage of people who would like to work full-time, but aren’t) rose back to 17.1%. The average duration of long-term unemployment rose, and weekly claims remain at very high levels.
Overall, though, it was the best report in years and shows that the economy is definitely improving, though at a slower and lower rate than usual. We still believe in the rebound rather than the “V” scenario, but all improvement is welcome. The Monster employment index (based on the job site Monster.com) also rose sharply
One thing that made us dig a bit deeper was trying to reconcile the fact that the report showed that more than half the gains (166,000) came from private services, yet the employment component of the ISM services poll released Wednesday showed a reading below 50 (though only just). That means contraction. Well, the ISM is a diffusion report, and sure enough a closer look reveals that many categories slowed, while some grew by quite a bit.
But it bothers us a little that wholesale and retail trade both slowed, while transportation and warehousing contracted. The last item was kind of dismissed as only couriers and messengers, but that doesn’t comfort us at all: one would think the category to be a highly sensitive leading indicator. Perhaps there is another explanation, or it’s only a one-off, but it bears watching.
Turning back to the ISM services report, the index reported an expansionary reading of 55.4, a little bit lower than consensus expectations for 56.4 and unchanged from the previous month’s reading. New orders fell sharply, but activity edged up slightly.
It’s clear from both responder comments and the diffusion breadth that the manufacturing rebound is going much stronger. Four of the eighteen service sectors reported contraction, but on the manufacturing side, none of them did. The manufacturing survey reported a robust 60.4, with new orders, production and employment all showing strong gains. ISM chairman Norbert Ore summed up the manufacturing recovery as “quite strong,” and expects “continued growth.”
We’d like to take this moment to point out two interesting facts. If you are one of those hard-core holdouts who insist that speculation in commodities is just an unfounded rumor, consider that every commodity but natural gas was reported up in price last month – but no commodity is reported to be in short supply. Interesting, isn’t it?
The other thing we’d like to point out that may come as a bigger surprise (it was to us), is that strength in the ISM manufacturing index has a poor record for predicting future stock market performance, at least over the last twenty years. Sometimes the ISM is coincident, sometimes it leads, sometimes it’s contrarian. The market often rises when the ISM is falling and goes nowhere while it’s rising; at times the market has fallen sharply on drops below fifty and other times it has risen. No doubt there is a good reason behind each episode, but as a single gauge it hasn’t been reliable.
Pending home sales for April and factory orders both rose strongly, as we predicted last week. However, our estimate that the stock market might rise similarly as a result was greeted instead with a two-hundred point plus drop in the Dow. Sometimes other factors outweigh the latest data.
Pending sales rose 5.3% in March, and should rise again in April due to the effect of the expiring tax credit. Similarly, mortgage-purchase applications closed out the last week of the credit Friday with a strong 13% gain. Our estimate is that the application level is about even or slightly lower with the last week of October 2009, when the credit was last scheduled to expire. Sales fell sharply afterwards.
Factory orders rose by a strong 1.3%, led by price increases in petroleum and coal. However, orders outside of aircraft and defense showed good strength, and there were upward revisions to February. It was a good showing.
Chain store sales for April were mixed, but overall below expectations. The weekly indications that pointed to a slowdown from the early-Easter March turned out to be accurate. The latest readings from the two principal weekly reports point to a flat-to-down reading for April retail sales. The consensus for that report, due this Friday, currently calls for a gain of 0.2%.
In other areas, revolving consumer credit continues to contract (credit cards), initial claims continue to hover in the 440-450k range and productivity is rising faster than expected, due mainly to labor costs falling faster. If you were worried about inflation, that’s good news, but if deflation is your concern, it wasn’t.
Next week is quite light on data until Friday. One imagines that will leave the stage to the Europeans and some high-profile earnings reports, such as Walt Disney (DIS) on Tuesday and Cisco (CSCO) on Wednesday. We’ll get data on international trade on Wednesday and prices on Thursday, but Friday will bring April industrial production and a new consumer sentiment reading to go with the retail sales report. If the Europeans can reassure the markets and Cisco holds up its positive tone, we could see a very decent result from equities for the week.
But if the Euros mess it up again, we think you know what will happen.
Avalon Asset Management Company is a Registered Investment Adviser
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