CFTC & SEC Release Report on Flash Crash of May 6th

The SEC and CFTC issued their report on the flash crash of May 6th today arguing that a single large investor, previously identified as Waddell & Reed Financial, entered a computerized selling order that caused a cascade of selling across the market. The report provides a good synopsis of what happened. Below are the notable excerpts from the report:

Summary

On May 6, 2010, the prices of many U.S.-based equity products experienced an extraordinarily rapid decline and recovery. That afternoon, major equity indices in both the futures and securities markets, each already down over 4% from their prior-day close, suddenly plummeted a further 5-6% in a matter of minutes before rebounding almost as quickly...

...Over 20,000 trades across more than 300 securities were executed at prices more than 60% away from their values just moments before. Moreover, many of these trades were executed at prices of a penny or less, or as high as $100,000, before prices of those securities returned to their “pre-crash” levels.

What happened in e-minis?

At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position...

...This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time...

...However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes...

...Between 2:32 p.m. and 2:45 p.m., as prices of the E-Mini rapidly declined, the Sell Algorithm sold about 35,000 E-Mini contracts (valued at approximately $1.9 billion) of the 75,000 intended. During the same time, all fundamental sellers combined sold more than 80,000 contracts net, while all fundamental buyers bought only about 50,000 contracts net, for a net fundamental imbalance of 30,000 contracts. This level of net selling by fundamental sellers is about 15 times larger compared to the same 13-minute interval during the previous three days, while this level of net buying by the fundamental buyers is about 10 times larger compared to the same time period during the previous three days.

What happened in equities?

Based on their respective individual risk assessments, some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets. Some fell back to manual trading but had to limit their focus to only a subset of securities as they were not able to keep up with the nearly ten-fold increase in volume that occurred as prices in many securities rapidly declined...

...HFTs in the equity markets, who normally both provide and take liquidity as part of their strategies, traded proportionally more as volume increased, and overall were net sellers in the rapidly declining broad market along with most other participants. Some of these firms continued to trade as the broad indices began to recover and individual securities started to experience severe price dislocations, whereas others reduced or halted trading completely...

...Between 2:40 p.m. and 3:00 p.m., approximately 2 billion shares traded with a total volume exceeding $56 billion. Over 98% of all shares were executed at prices within 10% of their 2:40 p.m. value. However, as liquidity completely evaporated in a number of individual securities and ETFs,11 participants instructed to sell (or buy) at the market found no immediately available buy interest (or sell interest) resulting in trades being executed at irrational prices as low as one penny or as high as $100,000. These trades occurred as a result of so-called stub quotes, which are quotes generated by market makers (or the exchanges on their behalf) at levels far away from the current market in order to fulfill continuous two-sided quoting obligations even when a market maker has withdrawn from active trading.

Lessons Learned

One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets...

...May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products...

...Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations...

...A further observation from May 6 is that market participants’ uncertainty about when trades will be broken can affect their trading strategies and willingness to provide liquidity. In fact, in our interviews many participants expressed concern that, on May 6, the exchanges and FINRA only broke trades that were more than 60% away from the applicable reference price, and did so using a process that was not transparent...

...Whether trading decisions are based on human judgment or a computer algorithm, and whether trades occur once a minute or thousands of times each second, fair and orderly markets require that the standard for robust, accessible, and timely market data be set quite high. Although we do not believe significant market data delays were the primary factor in causing the events of May 6, our analyses of that day reveal the extent to which the actions of market participants can be influenced by uncertainty about, or delays in, market data.

Accordingly, another area of focus going forward should be on the integrity and reliability of market centers’ data processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds. In addition, we will be working with the market centers in exploring their members’ trading practices to identify any unintentional or potentially abusive or manipulative conduct that may cause system delays that inhibit the ability of market participants to engage in a fair and orderly process of price discovery.

Download the full report here.

Thoughts on the "Bond Bubble", Equity Sentiment & Doctor Copper

Barclay's should make for an enjoyable afternoon

Today should be a good day to grab some quality tube time watching Tiger Woods' back nine when CBS kicks in coverage at 3:00 for the Barclay's. Woods followed up a huge round of 65 on Thursday with a relatively dismal 73. At 4-under overall he's 4 shots back and certainly in contention. Will the divorce clear his head and propel him to a win? I doubt it, along with some injuries Tiger Woods has not had the eye of the tiger all year (terrible joke). Ol' Mickelson missed the cut but he's never been a favorite of mine so I'm not too concerned that I won't get to see the beautiful short game coupled with a couple wild shots that choke away his chances of winning. My fellow Wisconsonite, Stevie Stricker, continues his day-in-and-day-out consistent golf ranking 5th in Ryder Cup standings and sitting nicely at 5-under for the tournament.

Bond market ticks down finally after momentum run, bubble talk is nonsense

The Treasury bond market finally ticked down on Friday with the 30-year bond dropping 3 points to now yield 3.69%. While I would not be a buyer of T-bonds at these levels all the bubble talk seems silly. While I would be the first to argue that these bonds are overvalued and they discount far too much economic malaise going forward at current prices, I do not see the bubble argument given the typical use of the term and what it refers to historically.

There's two great pieces out by Elliot Turner and Vince Farrell explaining the misuse of the term bubble. Recently, we've seen bubbles in the dot-coms where the Nasdaq collapsed from over 5,000 to less than 1,000 in 3 years, the oil bubble where prices collapsed from $147 to $33 in 6 months and the housing bubble where prices are still falling down 40-50% in some the key bubble areas.

Unless you're actually a believer that the US government is going to lose control and hyper-inflation is going to overwhelm us, the worst that happens in the bond market is investors lock-in a paltry return for the next 30 years. Many of the hyper-inflationists forget what open market operations are and how they work. The FOMC has more than doubled the Fed's balance sheet from $870 pre-crisis to $2.2 trillion by purchasing MBS and Treasuries. But, the debt is not retired, it is still on the balance sheet. This means the Fed has $2.2 trillion in assets it can sell back to the market to remove liquidity if inflation were to creep up on us giving it substantial inflation-fighting mechanisms to employ far before hyperinflation takes hold. How about we worry about deflation until we actually see some price inflation?

The bubble argument really only works out if there is a global loss of confidence in the US's ability to repay its debt and we completely default through hyperinflation. Forecasting this event is an extremely premature conclusion when you consider the Japanese situation where debt-to-GDP has risen to 200% (versus ours with high-end estimates at 90%) in a far less dynamic and innovative economy, yet rates on the 30-year bond are a measly 1.7%. So much for bond vigilantes in Japan.

I do recognize the argument that if you're investing in T-bonds as a way to guarantee capital then a relatively wild swing in prices could be very discomforting and inflict a good deal of pain to holders. But say bonds drop 10% or so, that is far from a so-called bubble in asset prices given its normal use in our lexicon.

Cramer's call for Obama to shape discourse is right

I rarely weigh in on political matters but Cramer has recently been critical of President Obama for his lack of leadership in the current climate and I agree. Cramer is onto something here and Obama should heed his call. The Federal Reserve has long understood the power of language and uses language within the policy statements to influence market perceptions. Obama can do the same thing!

Everyday, one after another CNBC guest comes on to highlight the climate of uncertainty for US businesses largely blaming the White House and Congress for causing it while forgetting the current state of the recovery. We are in the first hiccup in what has been, and will be, a very long recovery. The political argument is convoluted and there may be some merit to it but I'd refer to Occam's razor on this one: it's probably much more likely that hiring is slow because the economy has just gone through the most devastating meltdown in 80 years and businesses are hesitant to jump back in. As an aside, I think the 'flash crash' was a damaging event psychologically for the average investor and has yet to be adequately addressed publicly.

Does Obama really not understand the power he holds over markets? The stress tests in the US and Europe were a joke in many respects with a contrived grading system and a manufactured outcome. But, you know what, they worked! Investors granted the leap of faith that was required and created a self-fulfilling prophecy of stability by investing in banking institutions, re-capitalizing them and buoying the entire financial system in short order.

Obama has to understand that he can shape the discourse. He could easily reassure the public that their 401(k)s are an excellent mechanism for generating long-term returns despite the struggles we're experiencing, explain that safeguards have been enacted to prevent another flash crash and take a victory lap for the General Motors takeover and planned IPO. Even if I disagreed with the GM takeover in principle I still think it's very important to highlight the fact that the government is not interested in owning the company and plans to exit as soon as possible returning the re-capitalized company to private equity holders.

Recent selling feels like March 2009

While markets are 3.4% lower than when I wrote that I believed the long-term rally was back on, I am sticking with my argument despite the volatility we have seen. August has been a dismal month taking back about 2/3rds of July's gains but the selling this month feels like the despondency stage of the market emotion cycle.

I was telling a collegue that it feels a lot like the March 2009 bottom where traders just lose interest because it's just a dribble lower day after day. It's not nearly of the same magnitude but there are similarities I have recognized in my own outlook. Also, while I am not a big sentiment indicator guy, this one fits my thesis so I'll use it (solid consistent application, right?). Bespoke has a chart showing bullish sentiment at its lowest level since the March 2009 bottom. That would clearly figure given that this is the deepest pull-in since the rally began from that bottom but it's interesting nonetheless.

Source: Bespoke Investment Group

Doctor Copper says 'what are you worrying about?'

Copper is often a great indicator of forthcoming demand and has recently led equity market moves. Copper mounted a strong reversal on Wednesday through the closely watched $3.20 level and then powered higher on Thursday and Friday to re-challenge previous highs of the recent move off the June lows. Copper's move coupled with my feel for sentiment compelled me to dip my toe in SPY on Friday picking up about 1/5th of what I intend to scale up to should this rally find legs.

Below is a chart since the March 2009 bottom highlighting the moves in the S&P 500 represented by SPY and copper represented by JJC. Copper has either led by putting in a bottom earlier or the bottoms have exactly coincided. Surely this does not mean that we cannot go lower in both but copper has had a nice move higher lately that the market has yet to follow.

Links to some great posts making the rounds:

Interview with Justin Fox (The Myth of the Rational Market) ~ Wall Street Cheat Sheet

History of US Interest Rates: 1790-Present ~ The Big Picture

How (not) to Build a Market Indicator: The Hindenburg Omen ~ A Dash of Insight

M&A: Top or Bottom? ~ Investing Caffeine

Bonus: Great cartoon about living in New York titled "Miracle of Miracles"!

Source: gapingvoid gallery via The Big Picture

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Long SPY.