Are Structural Changes in Equity Markets Leading to a Loss in Confidence?

Just last week, Brandon put out a breakdown of some of the major structural changes taking shape in equity markets.  In sum, to a large extent, pricing has become far less transparent, with liquidity less reliable, where orders are broken down into small fractals in order to be executed.  The cause of the Flash Crash still remains a mystery, as some assert it was actually panicked investors rushing to the exits, while others maintain that it was the result of computer programs designed to respond to relative pricing shifts in other markets culminating in the “perfect storm” of selling.

The Flash Crash and the Investor Response

In the wake of the Flash Crash, hedge fund redemptions totaled a net negative $14 billion withdrawal from stocks and bond mutual funds. Ever since the March 2009 bottom, on net, the investing public had been putting money to work in US markets and on a dime that quickly changed.  According to Morningstar, investors had deposited $165 billion into US stock and bond funds leading up to the Flash Crash.  I can assure you that these same investors who kept piling money into markets despite the Dubai default in November, and despite the greater than 10% drop that started in late January and ran into February saw something different this time.

Mutual fund redemptions in aggregate are driven by the average person, not sophisticated investors.  Walking the streets in New York City and in speaking with my core group of friends and family, no one expressed a sentiment shift towards the economy because of Greece.  Just about everyone has maintained this sense that nothing really has changed since the Great Recession plunged equities to lows in March of 2009.  Meanwhile, consumer confidence itself was making recovery highs.  This is not the type of behavior that would lead the average investor to flee equity markets.

What exactly was different this time around?  Well maybe it has something to do with the psychology of seeing something there, vanish in the blink of an eye and then quickly reappear.  It makes everything appear illusory and it gives the perception that we see is not necessarily what meets the eye.  Moreover, it instills a fear that should things actually start collapsing, the computers would lead the rush to the exits leaving people staring like deer-in-headlights as their life’s wealth quickly vanishes.

The question to many becomes “in these challenging economic times, is it worth the risk to keep money invested in equities?”  I don’t even think most were thinking “is there a potential reward that justifies the risk?”  It was solely focused on the risk.  In the middle of a rolling credit crisis, it is far too important for most to not risk their savings than it is to generate a return on their savings, especially when most “safe” jobs aren’t even all that safe these days.

Since the Flash Crash, I have heard more people than ever proclaim that “it [the stock market] is all just a big game, none of which is real.”

The New Market

One prominent trader I know says that “program strategies have literally broken the market.”  Programs trade things off of each other, rather than some sort of underlying value.  Everything is valued in relation to each other, rather than to its fundamental value and this generates the problematic slippery slope where momentum reigns supreme.  Some of the volatile moves in markets lately are things we didn’t even see during the depths of the “financial crisis” time period.  11 days straight down and 6 days straight up.  Insanity!

ETFs have certainly changed the market.  They offer people the opportunity to diversify in a number of different ways.  There are long ETFs, short ETFs, sector breakdowns, double, even triple leveraged ETFs, commodities, bonds, derivatives…you name it, there is an ETF for it these days.  What does this all mean?  Well with ETFs taking an increasingly large share of the volume in US equity markets, transactions in ETFs are forcing buying and/or selling in their underlying assets.

Computers are programmed to buy or sell based on moves in seemingly related asset classes, generating rapid forced buying and selling that instantly reprices investment vehicles across a multitude of assets classes all at once.  This is a market in which mere “noise” can quickly snowball into a storm.  Correlation is resultingly at ridiculously high levels.  The synchronicity with which stocks and asset classes move together is historically high, and portends heightened volatility in the near-to-mid terms.  At the moment, no individual stock is safe, regardless of the different fundamental backdrop.  When stocks are sold, stocks are sold.

In the Myth of the Rational Market (check out my review of the book here), Justin Fox analogizes how noise in markets is much like the flapping of a butterfly’s wings in Brazil which leads to a hurricane forming off the eastern coast of Africa.  Well these butterfly wings are flapping in US equity markets everyday and it might just be a matter of time before the next ripple turns into a big storm.

Circuit Breakers and Steps to Build Confidence

In the wake of the Flash Crash, the SEC initiated new circuit breaker measures to halt a potentially vicious downward spiral in equities.  There has clearly been a recognition on the part of the SEC that there are some structural issues with the market; however there remains a cloud of uncertainty over whether the circuit breakers are in fact enough.

In the month of July, the technology sector (as represented by XLK) has greatly outperformed the S&P.  This outpeformance started when the tech sector bottomed before the S&P in November of 2008, and has continued throughout the rebound off of the market’s March 2009 lows.  In many respects this is demonstrative of the fact that investors are in fact confident to invest where there is the opportunity for outperformance and growth; however, with the economic outlook taking a turn for the more uncertain in recent months, selling has become far more persistent.

When there are real opportunities for investors to put money to work, the risks become much less of a concern.  So to a very large extent, this recent pull in (I maintain that this is a pull in and not a new leg down in markets) is a reaction to both the aggressive near 80% rally from March 2009 to April 2010, and emerging questions about future growth opportunities, rather than merely to market structure.  However, it is hard to ignore the role that market structure has played in exacerbating concerns over growth opportunities moving forward.

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