Retreat of the Robots

The HFT industry has perhaps squeezed out everything it could from the markets.

From Business Week:

According to Rosenblatt, in 2009 the entire HFT industry made around $5 billion trading stocks. Last year it made closer to $1 billion. By comparison, JPMorgan Chase earned more than six times that in the first quarter of this year. The “profits have collapsed,” says Mark Gorton, the founder of Tower Research Capital, one of the largest and fastest high-frequency trading firms. “The easy money’s gone. We’re doing more things better than ever before and making less money doing it.”

For the first time since its inception, high-frequency trading, the bogey machine of the markets, is in retreat. According to estimates from Rosenblatt Securities, as much as two-thirds of all stock trades in the U.S. from 2008 to 2011 were executed by high-frequency firms; today it’s about half. In 2009, high-frequency traders moved about 3.25 billion shares a day. In 2012, it was 1.6 billion a day. Speed traders aren’t just trading fewer shares, they’re making less money on each trade. Average profits have fallen from about a tenth of a penny per share to a twentieth of a penny.

Cash Crops

It is amazing/fascinating that so much value in commodity markets is captured by the trader intermediary.  From the FT recently:

Critically, the documents reveal profit growth more redolent of the explosive development of Silicon Valley start-ups than the centuries-old business of trading. The world’s top 20 independent commodities traders posted a record net profit of $36.5bn in 2008, soaring about 1,600 per cent from $2.1bn in 2000. Over the past decade those 20 trading houses posted profits of $250bn – more than the world’s top five carmakers combined….

All this has been built on revenues that have reached extraordinary highs. Sales from 10 of the world’s largest independent commodities trading houses – Vitol, Glencore, Trafigura, Cargill, Mitsubishi, ADM, Noble, Wilmar, Louis Dreyfus and Mitsui – last year hit $1.2tn, roughly equivalent to the gross domestic product of Spain or South Korea. Vitol alone had revenues last year of $303bn, slightly less than the GDP of Denmark….

Competitors are also daunted by the companies’ extensive intelligence networks. The traders monitor supply and demand worldwide – data that they then use for arbitrage trading. At its most basic level, they deploy people to count cocoa stocks in Ivory Coast or set up cameras to film coal stocks at Japanese power stations – all to determine the inventory fluctuations and price discrepancies through which they make their millions.

An even more controversial advantage for the trading houses, which now sets them apart from the big banks, is that they are largely unregulated. This too is causing consternation, particularly as the houses step into a funding void vacated by western banks. The government of Switzerland, the main hub of the trading titans, recently acknowledged the challenge in unusually candid language for an official report: “Physical commodities traders are, in principle, not subject to any oversight.”

The Tinkerers, the Hobbyists, and the Risk-Takers

This is from an interview with Nassim Talib on his anti-fragility thesis:

How would you make something antifragile?

If antifragility is the property of all these natural complex systems that have survived, then depriving them of volatility,randomness and stressors will harm them. Just as spending a month in bed leads to muscle atrophy, complex systems are weakened or even killed when  deprived of stressors.

If you want to move away from fragility, you must avoid centralisation and debt and foster aggressive risk-takers who are willing to fail seven times in a lifetime. The economy of the west was initiated through trial and error. We still have a pocket of that in California, where there are small costs of failure and big gains once in a while. The top-down approach blocks antifragility and growth, whereas everything bottom-up thrives under the right amount of stress and disorder.

Are you saying that capitalism is good, but that 21st-century capitalism has gone too far?

What we do today has nothing to do with capitalism or socialism. It is a crony type of system that transfers money to the coffers of bureaucrats. The largest “fragiliser” of society is a lack of skin in the game. If you are mayor of a small town, you are penalised for your mistakes because you are made accountable when you go to church. But we are witnessing the rise of a new class of inverse heroes – bureaucrats, bankers, and academics with too much power.

They game the system while citizens pay the price. I want the entrepreneur to be respected, not the CEO of a company who has all the upsides and none of the downsides.

There are plenty of open-minded individuals who weren’t upset by what I said. This coming book will upset bureaucrats and academics – academics because I suggest trial and error is superior to knowledge. The process of discovery, innovation, or technological progress depends on antifragile tinkering and aggressive risk-bearing, rather than education. A country’s assets reside in the tinkerers, the hobbyists and the risk-takers.

It is important to think of the consequences of a society where the rewards go those without skin in the game in some way.

Arbitraging Away Alpha

Almost 40 years ago, a Princeton economist wrote A Random Walk Down Wall Street, sticking a more catchy name onto what was known as the efficient markets hypothesis.  This is the idea, simply put, that it’s hard to find inefficiencies in liquid financial markets such as the stock market because all the information that is available is already incorporated into the price at any point in time.

One might have argued that the Masters of Universe fortunes made over the last decade and a half raised a serious challenge to that thesis.  But perhaps the thesis has come into its own, forty years after the most memorable statement of the thesis.

The FT has an article this week, positing that the less than stellar returns against market indexes over the last couple of years may, in large part, due to the combination of the sheer numbers of different sources of capital chasing yesterday’s hedge fund returns and the easy access to endless information in real-time.  Quoting from the FT:

But something more fundamental may be happening. Changes to the availability of information and in the capital to act on it mean it has become harder, perhaps impossible, to beat the market consistently through active management. There may be no more “alpha”.

Consider that any young business school graduate with the money to pay for the data feed can sit in front of a Bloomberg terminal and, with a few keystrokes, bring up years of financial statements for businesses across the globe. Tap again and an investor can ponder charts showing the predictions of professional analysts, details of the company’s debt, as well as the identities of shareholders, competitors and peers.

The service, and others like it that sit user friendly screens atop vast databases of information, have made it far easier to analyse asset prices, but harder to gain an edge over peers by acting faster, or more smartly.

John Longhurst, head of emerging market equity research for Pimco, says that when he became a stock analyst in the mid-1980s, “information advantage covering continental European companies was often little more than being able to get an annual report in English”.

Credit or Cash (Flow)? Which Game Is Being Played?

This week, I read this passage in the Economist:

This in turn sparked huge and occasionally destabilising flows of cross-border capital and a massive burst of credit creation. Total credit in the American economy passed $1 trillion in 1964; by 2007, it had exceeded $50 trillion.

This debt explosion showed up not in consumer prices but in asset prices, notably in property. The cycle was self-reinforcing: banks lent money to people to buy property, causing prices to rise, making banks more willing to lend, and so on.

It got me to thinking.  To understand the modern economy, you have to account for the general uptrend in availability and cost of credit as described above.  The fact that the supply of money has an effect on valuation of assets is simultaneously obvious and also deeply strange and unsettling in highlighting that the notion of valuation is inherently unstable.

To see why, let’s step back and think of valuation.  In simplest form, valuation is simply where supply meets demand, but the precursor question to that is how are the supply and demand functions set.  Among the approaches to valuation, let ‘s talk about two.

The first is a function of the discounted cash flows of the specific asset to be valued; the second is driven by the ease and availability of credit in the economic generally.  Where it gets interesting is when these two co-exist for the same asset and/or where there are both financial buyers (who are relatively indifferent to the asset other than as a store of value) and physical buyers (who will use the asset).

The most obvious place in our everyday lives where this is true is with housing.  One method of deciding a fair price to pay is figuring out the sum of discounted cash flows of what you could get (or would have to pay) if you rented the place.  Alternatively, you can just figure out what you can pay for something you like: the lower the interest rates are and the more credit is available, the more debt the buyer would be able to handle and the more she can pay.  The latter approach — considering what we could pay versus what we would rent it out at — wins out more in our economic culture.

In one sense, one can say it doesn’t matter which approach wins, as long from an individual level the risk is appreciated.  But, if you pay more than a home is worth from a rent/cash flow perspective because of a credit boom, then when the credit boom is over, you might find yourself deep underwater.  That’s where we are today and have been for the last five years in the economy.  So, the rub is that it does matter from a societal perspective, because distortions in valuation can have a serious aggregate economy-wide impact when they are way out of whack.  In other words, serious trouble can result if the game changes.

With the historical growth in credit, the credit approach to valuation seems to be more and more dominant in our economy, even beyond property.  The leverage needs a place to go.  For more and more markets, there seem to be both physical users as well as financial investors looking at the same asset.  What may have been at one point actual physical markets with a little bit of hedging are becoming deeper financial markets.

You see this play out in oil, coffee, food stuffs, private equity (the market for companies), in addition to real-estate.  More and more, such markets that, in the past, were driven by fundamental supply and demand from physical users are flooded with money from non-physical user investors.  These latter users are playing a different game — they are not necessarily concerned whether the underlying physical markets justify a valuation, but instead interested at their entry price and the attractiveness of the exit price.

On one hand, this is a problem in that it causes issues for buyers who need the physical goods.  So, why should individuals pay more for coffee or gas because of “speculators?”  On the other hand, those speculators/investors would argue that they are adding liquidity to the market, and give physical users a way to hedge and transfer some pricing risk.  These are not just problems for little people, filling up their gas tanks or paying an extra nickel for their cup of coffee: big companies regularly complain about speculation in their input markets.  For examples, airlines have been screaming about oil markets, and Starbucks has been complaining about the market in coffee beans.

These are real and hard questions.  This post does not answer them.  But here’s the lesson as players in non-financial markets.  It’s important to know what game you are playing — when you are selling or purchasing something, is the market being driven by cash flows, credit, or something else.  If you’re going to have to sell the asset, are the rules of valuation in the market going to change?  Are the valuations suggested by underlying cash flows and credit so out of whack that there is a lot of risk that things might readjust during your time frame?

These are important questions to consider because if the game changes on you, you can end up being the one played.

Let Them Drink Oil

To follow-up on my views on oil from a few days ago, let me describe a scary reality and a hopeful prospect of our efforts to free ourselves from the grip of OPEC.  In order to “let [their populations] eat cake,” the oil countries have, by and large, been spending money on benefits to their population to mute dissent.  Like, in our domestic situations, where states ramped up pensions when tax revenues spiked on the assumption that times would always be good, this has left the oil states dependent on high oil prices.

According to this week’s Economist:

The country’s oil minister, Ali Naimi, has said that $100 a barrel is fair. The Saudis are reckoned to need $80-85 a barrel to maintain a programme of lavish social spending designed to avoid an “Arab spring” in the kingdom. Iran, Iraq, Algeria and Venezuela rely on an oil price above $100 to keep spending on track and want the Saudis to cut production more.

The OPEC countries are telling us where they need the oil price to be.  It is no longer sufficient to have oil selling at $2o a barrel, $50, or even $75.  In today’s oil market, production and disruption in OPEC countries is the primary driver of prices, and within OPEC, Saudi Arabia, as it has the most spare capacity and reserves in the world, is the ultimate price kingpin.

The social spending pressures to placate their populations are not going away.  Thus, to the extent OPEC/Saudi Arabia retains the price-setting power, we are never going to pay less than we pay today for oil.

This makes it all the more important that, as I describe in the prior post, we reduce our dependence on OPEC.  There are three aspects of that: first, buying less oil altogether by cutting consumption; second, buying the oil we do from outside OPEC; and third, through those actions, changing the supply that acts as the price-setter in the market to pull the price down.  Since oil is a global market, for the oil we need even after we cut consumption, we also don’t want to be paying current prices.  The hope has to be that the ability to procure oil from outside OPEC by the United States, one of the world’s biggest oil consumers, will have the consequence of reducing the influence of OPEC and Saudi Arabia on those prices.

Punching Back Against OPEC and Oil Speculator Bullies

I am fascinated by this week’s coordinated release of oil reserves from strategic reserves in the US and around the world.  Twenty-eight countries combined to release 60 million barrels, with the US accounting for half of the release.  Some thoughts:

1) Twenty-eight countries taking action reflects fantastic leadership and coordination by the US and others.

2) This is bold and unconventional economic policy, constituting one of the most creative economic strategies we have seen employed during the economic crisis.  It is using David’s slingshot to hobble Goliath.

3) Economic policy is too often hamstrung by ideology.  This action looks past ideology, and the tired and predictable criticisms that this is interfering in the free market or pandering to the electorate or putting our national security at risk or not increasing domestic production.  This action is not cosmetic, nor is it shallow politics; it is good policy.

4) This action was clearly not meant to represent a permanent supply boost going forward.  So much of the criticism stems from this fact, as if it wasn’t obvious to the designers of the policy. But it is obvious that 60 million barrels is not that much in the scheme of things; three days of US or a day of global consumption.  (Indeed, it is only 4% of global reserves, so part of the message here is that this coalition has a lot of dry powder, so to speak.)  This action is about something else other than shifting the supply demand up.

5) It is about sending a message and introducing uncertainty to OPEC (interestingly, Saudi Arabia was consulted, as it itself has been disappointed by its inability to convince a number of other OPEC members to increase oil production to sustain a global recovery) and to speculators, by essentially telling them that a powerful counterparty is willing to call their bluff by taking the other side of a trade by going short oil. For those, who think this is some offensive move that distorts a pristine free market, think again.  The market is already distorted by the presence of both OPEC and speculators; the action by the governments is just pushing back against these forces that are distorting true supply and demand factors in the market.

6) OPEC distorts the market through artificial supply restriction through supplier coordination.  With cartels, the challenge with keeping the members together is the uncertainty that members can rein in supply and keep prices high.  There is always the temptation to cheat and sell more, whether openly or discreetly, particularly if someone else is going to make the sale anyway.  By introducing a huge additional factor for cartel members to think about — that sales may come out of reserves — it makes it harder for cartel members, particularly the smaller ones who need the revenues from oil sales, to continue to hold back supply, faced with the possibility that foregoing sales in the short-term is not keeping prices high anyway.  In that sense, the “symbolism” of tapping the oil reserve is a surgical move that may pay huge dividends beyond the short-term supply boost by weakening the resolve of oil-producing companies to hold back oil going forward.  In essence, the non-OPEC countries have shown OPEC that they can act as a cartel too.

7) Speculators and hedge funds have distorted the market by making and profiting from one-way bets on oil going up.  Any supply disruption news has been magnified by the financial money pouring into the oil markets.  Again, this sends a message to the speculators by introducing uncertainty.  First, for those caught by the news and the fall in oil prices, sustaining the pain of losses will make them more careful about the bets that they are making.  (Seeing whether we hear names of funds that have sustained losses in the coming days will be interesting.)  Second, it makes it clear to those making the bets that going long is not a sure bet, as they need to watch over their shoulder whether oil reserves will be released again, in response to an actual supply disruption or price runup by manipulation.  Again, tapping the oil reserves may prove to be a surgical move that pays big dividends by chasing some of the hot money out of the market, allowing fundamental supply and demand forces to set the market clearing price.  In essence, the government has shown that there is a huge force in the market willing to make the opposite bets to the one-way bets that the hedge funds have been making, and this may encourage some to take their bets off the table and find another casino.

Bill Gross and the Devil’s Bargain

I am not posting this to either endorse or oppose Bill Gross’s view (and although I have an opinion, I recognize there generally has been oversimplification of the issue in different directions (both in terms of Wall Street bashing and Wall Street apology)), but because I do find it interesting that the “Bond King” and someone who has benefited from the very trend that he is criticizing is the one saying this.  I am an admirer of people who can achieve success by mastering the world as it is, but not go around pretending that what they are doing is God’s work. Many are successful at the former, but few are also successful at the latter. There is something particularly refreshing about those who can do both, and something particularly annoying about those who fall short of both. (Of course, those who can figure out what God’s work is and truly accomplish that are those to be admired most, but these are probably the rarest of folk.)  Here is Bill’s quote from February’s Investment Outlook:

“Money would also become the economic and political wedge for profound changes in American society. Fifty years ago, the highest paid and most prestigious professions were that of a doctor or a 707 airline pilot who flew the “golden” route from Los Angeles to Honolulu. Today the yellow brick road begins on Wall Street or the City. Aside from supernova innovators such as Steve Jobs or Mark Zuckerberg, the money is made from securitizing things instead of booting and rebuilding America. The tallest buildings in almost every major city are banks, with tens of thousands of people shuffling and trading paper for a living. One of this country’s premier investment banks paid each of its 26,000 employees an average of $370,000 in 2010, nearly ten times the take-home pay of other American workers. Almost a quarter of the 400 wealthiest people on Forbes annual richest list make their money from money, whereas only 8% could make that claim in its first issue in 1982, and probably close to 0% when I first read my economic primer in 1966.”

Icahn out, Halbower in

In the week that Carl Icahn announces he is returning outside money, Matt Halbower of Pentwater embarks on a new activist situation.  Halbower is a Harvard Law educated arbitrage, activist, and event-driven investor who uses his legal chops to find situations where there is potential value often through strategies that are in some way legal driven or where the markets are misreading some situation.  I have absolutely no opinion on the merits of the current situation, but Halbower is someone talented to follow if you are interested in investing.