Hard to Hold: Why investors should avoid an “out of control” market

Norma Jean - A turbulent life and a turbulent market.

Legendary film icon Marilyn Monroe once said “I’m selfish, impatient and a little insecure. I make mistakes, I am out of control and at times hard to handle, but if you can’t handle me at my worst then you sure as hell don’t deserve me at my best“. These words have been applied to the life of who many consider one of the most intriguing and beautiful actresses to ever grace the silver screen and can also be applied to the expected reaction of investors who find the recent market to be “hard to handle” and “out of control”. It will become evident that a volatile market is truly a market at “its worst” and investors and traders will surely, over time, not be able to “handle it”. They will most likely abandon the market, (maybe all at once), leaving investors once again “alone” with
their losses.

My prediction of a “15-20% decline in the equity market this summer”, which I made in my Forbes blog on May 23, 2011 entitled Cheating Gravity: Is the market rebound over?” and again in my blog posted on June 21, 2011 entitled Unraveling: The economic recovery that wasn’t and how to invest through the declines ahead”, came true on Tuesday, August 10, 2011.

The market decline happened just days after myMarch/April prediction of “an SP downgrade of our nation’s debt by the middle of the summer to AA+” came true on August 5, 2011. I had predicted the downgrade in
my blog of March 28, 2011, entitled Post interlude: How To invest During the Curtain Call of the Market Rebound and again in my blog posted on April 26, 2011 It’s a long way from wrong to right”. Both predictions were made in assorted international financial publications and various television appearances which confirm the accuracy of the predictions.

Within days if not hours of the market reaching my target decline of 15%, we witnessed one of the most volatile weeks in the history of the equity market – the end result being a 1.7% percent loss in the S&P 500 by week’s end, leaving many unanswered questions in the minds of investors.

WHAT IS CAUSING THE VOLATILITY?
This week the Dow swung more than 400 points 4 days in a row with extremely high volume especially during the “dog days of summer”. This roller coaster of “hard to handle” mood swings is being created by mostly “institutional high frequency trading” which is also referred to as “algorithmic trading” or programmed trading. This is when institutions and traders buy or sell large blocks of stock by using computer programs which rely on algorithms, making decisions based on aspects such as timing, price, or quantity of the order. In most cases, “the computer speaks and the traders listen”.

It has been estimated that 50% or more of all trading volume in the U.S. stock exchange is caused by “high frequency” or algorithmic trading. On a usually low volume trading day in August it’s possible that the trading volume exceeded 50%, especially with many “everyday” investors on vacation. The “flash crash” of May 6, 2010 has been blamed on high frequency/algorithmic trading by the Securities and Exchange Commission, a frightening day in which we saw the DOW fall 1,000 points in minutes.

WHY HIGH FREQUENCY/ALGORITHMIC TRADING CAN LEAD INVESTORS TO MAKE IRRATIONAL DECISIONS.
High frequency trading has been a profitable business to the individuals and institutions who utilize these strategies and they can be an effective tool to use as a means of diversifying a portfolio in combination with other Macro strategies. However, large institutions that use this type of strategy with the ability to “move” large blocks of stock and produce big swings in the price of the stock can create an “illusion” as to what the value of the stock is.

High frequency/algorithmic traders have no concern for fundamentals, geopolitical issues or economic issues. To quote one top high frequency trader “I pride myself on being entirely market neutral, no matter what’s going on in the market”. In other words, “the computer talks and he listens”.

Most high frequency/algorithmic traders start the day in cash and end in cash with the discipline to not become “emotionally attached to any stock”. As a stock moves up (or down) the high frequency trader will quickly take profits sometimes in seconds always with the goal of going to cash at the end of the day. If the “everyday investor” views this price appreciation as a fundamental improvement in the stock after being indoctrinated by the biggest lie on wall street “buy and hold”, they will be stuck holding a sometimes artificially inflated stock overnight which could be affected by such factors as foreign markets, earnings or warnings often released after the bell and have no opportunity to sell. These investors are often left to “hold “an artificially inflated stock for days, months or even a lifetime because they reacted to an artificial price move.

WHY DECLINING MARKETS BENEFIT HIGH FREQUENCY/ALGORITHMIC TRADERS AND HURT REGULAR INVESTORS.
In declining markets high frequency/velocity traders have the ability to short (bet against) the market while most everyday (buy and hold) investors rarely have the ability to short and rarely have the trading speed to compete with institutions as they close out their trades. As institutions move large blocks of stock, smaller sell orders are often “boxed out” and if they try to sell, they rarely get the price they intended to get.

A short position can get destroyed as big institutional orders often take precedence over other orders. Again investors are left holding stock “feeling like the sucker in the room” because they believed the price appreciation illusion created by the institutional high frequency traders. It is for this reason that I anticipate another flash crash before 2012, which could destroy investors in an instant if they aren’t properly prepared.

WHAT IS THE REALITY – A CASE FOR BEARISHNESS?
1.     EUROPE IS ON THE VERGE OF COLLAPSE – The Italian economy will collapse starting with the banking system. Spain will be soon to follow, sometime by the end of 2011. The European Central bank has no ability to handle a collapse of this magnitude and the contagion will spread to the American banking system.

2.     WE NEVER LEFT THE RECESSION AND THE FEDERAL RESERVE IS OUT OF OPTIONS TO STIMULATE THE ECONOMY (ALTHOUGH THEY WILL TRY) – This due to Bernanke’s statement that he would keep interest rates low until 2013. This statement and assignment of a timeline for keeping interest rates low will create two major problems:

  • First, it forces Bernanke to “get creative” and invent some way to keep interest rates low without having investors believe this is another failed government stimulus program.
  • Second, whatever this stimulus program will be called, it will ultimately add liquidity and usher in stagflation; we will see commodity prices surge once again, an artificial equity market rally and artificially high bond prices and
    low yields. For a central bank whose strategy to stimulate the economy is best described by a quote from Will Rogers – “if stupidity got us into this mess than stupidity can get us out”.

3.    THE MARKET IS OVERLY VOLATILE AS DETERMINED BY THE VOLATILITY INDEX OR VIX – The VIX traded at levels not seen since the collapse of the financial markets in 2008, which indicates a high level of fear. High VIX readings causes me to become more bearish despite market swings, due to one fact – “fear becomes more prevalent in market downturns than a desire to profit in up markets”. If a market should sell off radically which I would define as 400 points or more, fear and panic can take over and we run the risk of another “flash crash” or market crash. If the market advances 400 points, investors will be much quicker to take profits with the acknowledgement of the risk of adverse circumstances evolving in the future. This due to the many negatives the market faces, as well as the
acknowledgement that high frequency/algorithm traders are inflating stocks and will be quick to sell when their computer models tell them to.

HOW TO INVEST IN THE DECLINES AHEAD

  1. CONTINUE TO BUY GOLD through ETFS like SGOL. Although the CME has increased margin requirements as an attempt to slow the appreciation of gold investments to curb what they call “speculation” or what we call investment. It’s evident that the government considers the appreciation of gold an insult to their
    destruction of the dollar so they chose to step in and slow down the inevitable. Individuals have lost confidence in our currency and governmental manipulation of currencies around the world and this has increased the psychological value of gold. I see appreciation of 20-25 % in gold prices by the end of the year; this 4000 year old metal will prevail as a symbol of stability and with continued increase in demand with low supply, gold has never looked better.
  2. BUY INVERSE ETFs like SH (proshares short SP 500) and EFZ (proshares short MSCI) which will benefit from declines in the MSCI or foreign markets.
  3. BEGIN TO ACCUMULATE SHARES OF COMMODITY BASED ETFs – as the Federal Reserve moves closer to initiating its next stimulus plan. Among my recommendations are:
  • ETNs like JJG (ipath Dow Jones grain total return sub index)
  • JJC (ipath dow Jones)
  • UBS copper total return sub index
  • And virtually any other commodity with high demand/low supply, as the
    central bank will certainly inflate them once again.
  • I would buy OIL and any ETF/ETN linked to oil prices

In the end, life for Norma Jean Mortenson (Marilyn Monroe’s real name) was tragic. She was raised in an orphanage, married and divorced three times and died alone at the age of 36. I can’t compare what’s going on in the economy with this tragic, turbulent life except to say that we could all use one of her simple quotes to help us persevere in the days ahead – “We should all start to live before we get old. Fear is stupid. So are regrets”.