STACKED DECK / BARRON´S MAGAZINE ( VERY HIGHLY RECOMMENDED READING )

Up and Down Wall Street

SATURDAY, AUGUST 28, 2010

Stacked Deck

By ALAN ABELSON

A POLISH CHAP LIVING IN GERMANY went to the doctor, so reported the BBC last week, complaining of what he thought was a cyst in his scalp that turned out to be a .22-calibre bullet lodged in the back of his head. The bullet had not, fortunately, penetrated his skull and it was duly removed.

People get plugged all the time these days, of course, but supposedly this happened in 2004 or 2005. In other words, this poor fellow had been carrying around the bullet in his head for five or six years.

The victim, apparently, of a stray celebratory bullet fired at midnight during a New Year's party, the man claimed he was too soused to be aware of being shot but allowed as he felt as if he had received a blow to his noggin. So how come he waited all this time to do something about it?

He explained to the police that although he did remember having a sore head, "he wasn't really one for going to the doctor." We can only conclude that not only is he blessed with a remarkably hard bean, but he also must have a visually impaired barber. Or, maybe it's the latest fashion in Germany to walk around with a bullet in your scalp.

To Société Générale's Albert Edwards, who recounts this incident in his latest market rant, the fellow's lack of awareness is akin to the blithe insouciance of equity investors to the prospect of the global economy sliding back into recession, accompanied by another leg down in the bear market. "The vast bulk of the investment industry," he exclaims, "fails to appreciate that we are locked in a structural bear market" that is about to enter its "final, even bloodier phase."

Albert repeats his oft-voiced conviction that the bear market won't end until stocks become dirt cheap, with the S&P 500 some 800 points below its current price of around 1050 and, equally important, "revulsion in equities as an asset class hangs in the air like a fog."

He contends that excessive valuation is particularly true of our market, but warns that other markets just about everywhere, even those less richly priced, will not escape the full fury of the raging bear. We think we're safe in characterizing his foreboding as not an optimistic forecast. However, his prediction of 250 on the S&P 500 does smack a bit of excessive devaluation.

But we second his notion that the surest sign of a true bottom will be when investors en masse become thoroughly sour on stocks—as they were, as we recall, at the end of the great 1973-74 bear market. Such total disenchantment was decidedly lacking in the aftermath of the dot-com bust and the 2008-early-'09 collapse, despite the enormous damage both ugly episodes wreaked on investors' net worth. Enthusiasm for equities was temporarily chilled but far from extinguished. As Exhibit A, we offer the rousing 80% rally from last year's depths.

However, we don't think investors have been quite as comatose as Albert suggests. For one thing, there has been something of a stampede out of stocks into bonds in a desperate search for yield in a zero-interest environment. In the process, government bonds gained a formidable 1.8% in this fading month, while the Dow lost 3%.

But most importantly, individual investors feel, as Alan Newman of Crosscurrents puts it, "the deck is stacked, the game is rigged against them." And they feel that way because it is. As Alan laments, "The public has gotten the shaft from Wall Street, from the SEC, from short-oriented hedge funds and now from high-frequency trading."

The market everyone knew, he says, has disappeared, and in its place is an arena in which the long term not only doesn't count, it doesn't exist. Indeed, we suspect that the metamorphosis from exchange to casino is the root of individual investor disaffection. And the singular virtue—if that's the word—of the ultimate meltdown Albert Edwards is yearning for would be to clear the air, restore the long-term to its rightful place in the investment quiver and eventually restore Jane and John Q.'s faith in the stock market.

Did we hear somebody say, "Dream on"?

OUR RATHER BLEAK OUTLOOK FOR EQUITIES is in no way diminished by Friday's dead-cat bounce, inspired by that fancier of deceased felines, Ben Bernanke. Speaking at the annual central bank hootenanny at Jackson Hole, Wyo., Mr. Bernanke gave eloquent point to Harry Truman's famous crack about how he'd love to find a one-handed economist who wouldn't be forced to revert to that profession's well-known tendency to reply to every question with on the one-hand this, on the other hand that.

We pored over the text of his speech, all 19 pages of it, and we have to admit it was quite comprehensible, in welcome contrast to the all-but-indecipherable mutterings of Alan Greenspan. And to his credit, Bernanke acknowledged that the recovery is hardly what it might be. Alas, when it came to sharing with us his blueprint for a swifter, more sustaining recovery, he reverted to the old wishy-washy it all depends.

What it all depends on is the recovery which seems to us, anyway, in dire need of resuscitation. Either Mr. Bernanke doesn't really have a grip on the dismal state of the economy, which is doubtful, or doesn't know what to do about it, which is downright discouraging.

What the Street seized on as an excuse to rally after the market's trashing earlier in the week was the chairman's articulation of what the Fed might do in the way of monetary easing if the economy continued to drag. He listed three possibilities: a resumption of so-called quantitative easing (QE, to use the Street lingo), which involves fresh purchases of longer-term securities; reducing the interest rate on the reserves banks hold with the Fed, and changing the statement issued after Federal Open Market Committee meetings to reassure investors not to worry that rates might go up in their lifetime.

Fiddling with the interest on bank reserves and happy talk in the post-FOMC meeting blah-blah seem pretty meager antidotes for what ails the economy. So it all comes down to QE and the evidence that it has a real and necessary impact is slim at best. Which suggests, we're afraid, that the Fed is out of live ammunition.

O.K., so why is the stock market rallying? You tell us.

"THE MARGINALIZING of the Individual Investor" is the title of a piece Harald Malmgren and Mark Stys penned for the summer edition of International Economy magazine. Mr. Malmgren runs the eponymous Malmgren Global, which advises financial institutions, sovereign wealth funds and a scattering of governments and central banks around the globe. Mr. Stys is chief investment officer of Bluemont Capital.

We personally know neither of these gentleman, but Malmgren was kind enough to send us an e-mail and a copy of their article, which has the jazzy subtitle of "the inside story of flash crashes, systemic risk and the demise of value investing."

It's an excellent job of analyzing High Frequency Trading and the rest of the algorithmic crew and describing their baleful effects and we strongly recommend you try to get your hands on a copy of the magazine. As it happens, their theme is right in keeping with our riff above on what's essentially eating the individual investor and wrong with the market.

In his cover letter, Malmgren describes the extensive research he and Stys did into high-frequency trading (HFT, for short). They queried the HFT operators on everything from their funding to how they interacted with the big financial houses and why they were eager to achieve global reach.

High-frequency trading, Malmgren and Stys note, is focused solely on ramping up speed and volume to maximize tiny gains. And they assert: "Investment strategies based on fundamentals have been swept aside by high-frequency algorithms hunting for inefficiencies in daily prices and super arbitrage opportunities."

As a result, individual traders, they report, are confronted with overwhelming momentum-driven forces unrelated to corporate performance. A 'fair price" may exist, but "high-frequency traders are not seeking fair prices—they are focused solely on immediate profit."

And, add Malmgren and Stys, "unfortunately, high-frequency trader interaction with computerized algorithms of large-cap financial institutions is providing opportunities for virtually undetectable market manipulation."

They point out that "in an environment where the range and speed of price movements is ever-increasing, fundamental valuations of a company would seem to be increasingly arbitrary without the ability to distinguish accelerated price movement from actual value."

Malmgren observes that HFT provides an illusion of almost limitless liquidity, liquidity that can vanish abruptly if a few HFT platforms take a break. Implicit, he says, is "mammoth systemic risk."

And since high-frequency traders have become the dominant market makers and shakers, their capacity to turn on a dime and sell off everything, means that a market correction could go much faster and far deeper than the Street imagines.

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