Eugene Linden
A well-trodden meme of TV and cinema has been the plot in which someone or something uses tantalizing illusions to sap humans of their will to resist while simultaneously pursing hostile ends. In The Martian Chronicles, the subtle race of Martians distracted the invading Americans with irresistible life-like illusions that spoke to their most intimate yearnings; in one episode of the X-Files, a fungus slowly digested an unlucky couple who lay in a field and were rendered completely passive by the fungus’ hallucinogenic properties. And then, most famously, the machines of the movie The Matrix ruled over a ruined wasteland and seduced people with a beguiling virtual reality in order to maintain their passivity while they tapped humanity’s body heat as an energy source.
Now, a lot of investors believe that life is imitating art in an alliance of the Federal Reserve and the big banks to create the illusion of healthy equity markets despite massive retail equity withdrawals in the years following the financial crisis. In this broadly-believed scenario the Fed’s motives are comparatively benign – to foster asset inflation that improves animal spirits, fosters a wealth effect, and restores access to the equity markets for financial institutions and other companies in need of capital.
The idea is that through its program of quantitative easing the Fed is buying treasuries from its primary dealers who then turn around some portion of the proceeds in the equity market. Data miners have discovered strong correlations between the Fed’s permanent open market operations (POMOs) and up days in the equity markets, with a statistically significant spike on such days during the final 45 minutes of trading. So strong is the perception that these operations pump the market that Bernanke’s announcement of a new quantitative easing program last August set off a rally that moved the market up over 14% before the program was scheduled to begin in November.
Whether or not there is a direct connection between QE and a bid for stocks, the mere fact that the link is so widely believed has played a non-trivial role in the equity markets. Which begs the question: if the markets have risen on this scenario, does it matter whether or not this connection exists? After all, millions of investors have been benefitting from the ride. The cynical answer is that it probably does not matter -- if such manipulations could continue in perpetuity.
There’s the rub: nothing continues in perpetuity. In fact, QE2 is scheduled to end around mid-year and if it is not extended, the markets will face a crunch whether or not there is a real connection between QE and the market. Thus, if the Fed will not (or cannot) extend QE past June, it behooves its officials to convince investors well beforehand that it has not provided the invisible hand supporting stocks. Regardless of the Fed’s role, there have been other, more disturbing bits of evidence that we are in a Matrix Market.
Exhibit One is the so-called “flash crash of May 2010 during which stocks fell by 600 points in five minutes before staging and equally vertiginous recovery. The crash offered evidence that something truly scary lay behind the reassuring façade of buoyant markets. Subsequent investigation revealed that High Frequency Trading, which relies on algorithms to execute superfast trades, exacerbated the collapse. Revelations about the extraordinary percentage (sometimes over 80%) of trading attributable to HFT programs in stocks such as Citi and AIG suggest that the metaphor of a Matrix Market may be literally as well as figuratively true, and also helped explain how a market suffering continuing retail withdrawals could still rise to a multi-year high during a very weak economic recovery.
Economist Michael Hudson of the University of Missouri calculated that the average time a stock was held during 2010 was 22 seconds, not exactly buy and hold. Of course it’s entirely possible that both HFT and the impact of the Fed’s easing program are overblown; that the market’s rise can be simply explained by solid corporate earnings and the perception of a real recovery. If that’s the case, the market will continue to plug higher so long as the recovery story remains credible to investors and earnings hold up. If, however, the rally is largely an artifact of the jet fuel supplied by the Fed and amplified by algorithmic trading, then watch out.
The recent example of the auction-rate securities market shows that fake markets can seduce and then trap the most sophisticated investors. Adapted for municipal finance in 1988 by Goldman Sachs, the market grew to about $300 bn before it collapsed amid a series of failed auctions when the main players – Citi, UBS, AG, MS, and ML – pulled back from their practice of being the bidders of last resort. What was revealed subsequently was that for several months before that, auctions had basically been a sham with the big underwriter banks supplying the majority of bids for the securities they helped issue. Given that the investors were institutions and high net worth individuals, it’s remarkable that this could carry on so long without being uncovered. The ARS market was doomed in March, 2007 when FASB announced that ARS should not be counted as cash on balance sheets and liquidity began to dry up. From that point on the auction rate securities market was a ghost.
Those who paid attention (which did not include me) saved themselves much grief. Others remained oblivious for eleven months before the axe fell, and when it fell, it fell suddenly – one week after the first cracks appeared in the market 80% of the auctions that priced the securities failed. In hindsight it’s obvious that during that “dead man walking” period it was in not in any underwriter or broker’s interest to say that the ground had fatally shifted under what had been a highly profitable market. This was not a grand conspiracy or racket, but, more likely, a series of individual crimes as like-minded players continued a game because they could see no alternative. I’m sure that many of the players were amazed that it continued as long as it did.
Something similar happened in the mortgage-backed securities market as firms such as Bear Stearns continued to package and push them on investors long after it became obvious that the underlying mortgages were going sour in unprecedented numbers (when the MBS market finally did collapse new issuance went from hundreds of billions annually to zero). Something very similar is going on right now in the commercial real estate market where lenders are extending maturities because no-one wants to face the consequences of setting off a cascade of defaults and subsequent massive write-downs in a weak market. Is something similar going on in the equity markets?
For sure, we’re gonna find out, probably by mid-year.
