Jan 01 The Bear's Lair: 2015 should see the return of ‘fast markets’

December 29, 2014 posted by Martin Hutchinson

While oil prices have been volatile in 2014, stock prices haven't. The U.S. stock market has continued the gradual upward move it began in 2009, while the volatility index (VIX) peaked very briefly in October at 31, far below the level of almost 90 touched in 2008. Politics have been turbulent, and the oil-price decline has been significant by any standard, but equity investors have enjoyed a tranquil and prosperous year. It’s the latest of several years in which price changes have been gradual and generally upward and market and economic changes have been slow. For a number of reasons, 2015 promises to be very different and to see the return of fast markets, in which trading speeds up, prices jump all over the place and volatility spikes. For retail investors, it won't be an enjoyable experience.


"Fast markets” is a term used by the New York Stock Exchange (NYSE) and other markets to define market situations in which price discovery is impossible because trading is too chaotic. For example, NASDAQ defines it as "excessively rapid trading in a specific security that causes a delay in the electronic updating of its last sale and market conditions, particularly in options." You'd think fast markets would become impossible with electronic reporting, but as we saw during the 2010 "flash crash," electronic systems can themselves generate a volume of orders that overwhelms the normal market-making mechanisms and causes prices to leap about uncontrollably.

The term "fast markets” is relatively new, I believe dating back only to the 1990s, but the reality is a century old. During the "Black Tuesday" trading of Oct. 29, 1929—when a then-record 16 million shares changed hands on the NYSE—the electro-mechanical ticker tape ran fully six hours late. It was thus impossible for any investor not present on the floor of the Exchange to know at what prices shares were being dealt. The same phenomenon occurred on Oct. 19 and 20, 1987, even with the much quicker electronic reporting available by that time. Although the delay never stretched beyond an hour-and-a-half, it was sufficient to cause panic among market-makers and send S&P 500 futures prices well on the way toward zero.

The fast-markets phenomenon is inexplicable under conventional market theories such as the Efficient Market Hypothesis. These assume that markets are Gaussian and that one day's trading is more or less like any other, except possibly for differences in "volatility," that magic number that explains all trading anomalies. However, while theoretically impossible under modern financial theory, fast markets occur with some frequency. The trading in those markets is different not just in volatility, but in nature from that in calmer periods. The best analogy is to the flow of water through a pipe. As fluid dynamicists know, it can change in nature with additional velocity, becoming turbulent instead of streamlined and obeying a very different set of dynamic equations.

In fast-markets periods trading is mathematically chaotic, price discovery is not well behaved, prices leap by arbitrarily large amounts and, while trading volumes are exceptionally large in general, trading can cease altogether for periods of time during which there is no price at which buyers and sellers can be matched.

During the six years since the 2008 financial crisis, fast-markets trading periods have been infrequent, occurring only when computer generated algorithms have destabilized the market, with no rationally assessable news event or valuation change behind them. In 2015, this is likely to change, and it is worth setting out why this change will probably occur this year.

First and most important, the cheap money policies pursued by Federal Reserve (Fed) chairs Ben Bernanke and Janet Yellen since 2008 (and by Alan Greenspan since 1995) have vastly increased the leverage in the U.S. economic system at the retail, corporate, financial and government levels.

Consequently, they have made the system much more unstable. A sustained period of tight money in 1994 (which, with a top interest rate of 6% and a duration of only a year, was mild indeed compared to Paul Volcker's tightening in 1979-82) produced severe pain only in Wall Street. But today such an equivalent period would cause a "house of cards" financial-markets collapse by reducing asset values throughout the system. Debts suddenly would become worthless, and valuations, which had appeared soundly based, would suddenly be perceived as built on sand.

Optimists will opine with considerable justification that no power of heaven or earth is going to make Janet Yellen increase interest rates except by the tiniest amounts, so a collapse of asset values across the entire economy is very unlikely. We may descend into hyperinflation—and we are undoubtedly year by year decapitalizing the U.S. economy and making it less productive and more unstable—but a full-scale credit crunch must be regarded as a low probability, black swan event.

However, higher interest rates are not at this stage necessary to produce fast markets. The decline in oil prices from $100 a barrel to just above $50 has weakened asset values throughout the U.S. shale, tar-sands and deep-sea drilling sectors. This in turn will cause an explosion of losses and negative cash flow in many corporations, some of them surprisingly far from the sectors that are apparently worst affected.

The steady rise in stock prices over the last six years has been fueled by earnings at a historically exceptional level in terms of Gross Domestic Produce (GDP), with prices further boosted by massive stock buybacks—$55 billion in 2014 by Apple alone. Unlike 1999, stock prices are not grossly inflated in relation to earnings. But earnings themselves are inflated, and leverage is boosted by the artificial stock repurchases, which certainly do not increase the stability and value of the underlying, over-leveraged companies.

Hence, anything that causes a dip in corporate earnings is likely to have a disproportionately severe effect on the market, as valuation metrics that had appeared reasonable in terms of inflated earnings become highly unreasonable as earnings revert to a more historically normal level. Again, the most likely catalyst for such a reversion is a rise in interest rates, but the current tsunami in the oil sector may well be sufficient to affect a necessary proportion of U.S. corporations as to topple the unsteady edifice of current valuation metrics.

Such a reversal looks increasingly likely. The five percent increase in third quarter GDP, fueled by increased consumer spending, is an example of how the benefits of lower oil prices are coming before the costs. However, in 2015 the costs will begin to appear, and profitability will be affected. This reflects the tapering off, as Chinese wages rise, of the massive benefits from globalization that have propped up the profits of U.S. multinationals. It can be expected to accelerate in 2015. At some point, even the doziest investors will notice.

However, beyond oil and corporate profits generally, the most likely catalyst of fast-markets trading in 2015 is a fall back to earth in the tech sector. Too many companies in that sector have decided they are above the vulgar necessity of actually earning a profit. This is not just a short-term phenomenon. Amazon has a market capitalization of $140 billion without ever having produced more than a marginal profit (its current trailing P/E is infinite, its forward P/E a relatively conservative 343 times earnings). And smaller companies such as Angie's List have managed to exist for almost two decades without making a profit at all.

At some point investors will stop buying dreams and start insisting on reality. With the turbulence to be expected elsewhere, it's likely that their belated realization—which may look rather like William Holman Hunt's 1853 masterpiece "The Awakening Conscience"—will take place in 2015. At that point, investors, realizing like Holman Hunt's mistress the true horror of their position, will see that without profits, there is nothing to support sky-high valuations, and market "volatility" will reappear with a vengeance.

Lengthy periods of prosperity can continue for a very long time if they are intrinsically stable. But the current upswing, in which stock-market valuations break new records while the economy moves ahead only sluggishly, is highly artificial. It is born of monetary, and to a lesser extent, fiscal policies of record-breaking profligacy. In 2015, reality is likely to dawn on investors, triggered by huge losses in the oil sector and the potential for huge losses in tech. The market will react accordingly. Fast markets will be a symptom of the new reality.