David's Macro Blog

British humor we can all understand.

Somehow this seems to explain the situation better than CNBC. Why is that?

The belief in a recovery from the global economic collapse in 2008 has gained strength as the unemployment rate has leveled off, the stock market has recovered about 70% and real estate prices have stopped falling.

However, do we really have an organically growing economy or something else?

A great description of our recent economic experience comes from Bloomberg’s Caroline Baum:

Here’s a list of things we should expect in a true recovery:

• Increasing bank lending
• Growing credit use by consumers
• Increasing labor participation rate
• Increasing hours worked
• Increasing interest rates
• Decreasing unemployment (yes it is a lagging indicator)

Some far there is “no real muscle” because we don’t see any true signs of rebound in the economic and financial systems. Sure, the stimulus can temporarily bump up retail sales and the stock market, but long term it can’t.

Judge for yourself. Which do we have, an economy on life support or a real recovery?

In my opinion, we’ve been headed for a double dip recession ever since massive amount of stimulus was injected into the economy. Once that stimulus is removed, the double dip will commence. In reality we never left the first dip — we just momentarily suspended the decline.

Jon Stewart, one of the most astute and insightful commentators of our time, explains the May 6th 2010 Flash Crash in this video from the Daily Show: A Nightmare on Wall Street

If you are a day, swing, or momentum trader, how would you trade in this market? Did trading on May 6th blow through all the sell stops on the order books?

Well, I have one friend who is an accomplished trader and he related his strategy regarding this issue. He refrains from trading if the market moves too violently or if there isn’t a clear reason for the market movement (e.g. a war, terrorist attack, major corporate bankruptcy, etc.)

One supposed benefit of an electronic marketplace and program trading by black box algorithms (algos) is market liquidity that would prevent just this type of collapse. The October 19th 1987 Black Monday crash was supposedly caused by computer program trading. It happened again this time — did we learn anything?

Or, as the saying goes:

History is the same events happening to new people who experience it for the first time as though it never happened before.

On Thursday May 6th the stock market took a unexplained and terrifying plunge down 10% during the day.

This highly unusual event called the “Flash Crash” can be seen in real time on CNBC as Erin Burnett is interviewing Jim Cramer on Street Signs.

There are many (some conspiracy) theories as to the cause of the “flash crash,” which call into question the robustness of our nation’s financial systems.

How robust and sound is our financial system when the stock market can fall 10% intraday or about one trillion dollars?

Here are a few of the reported potential causes and conspiracy theories that may have triggered the crash.

• A trader made a “fat finger” error and pushed the wrong key on his keyboard selling a unusually large amount of contracts which exceeded the supply available. This is essentially a typo error.
• There was a large legitimate sell order on the S&P e-mini futures contracts which caused all markets globally to react and recalibrate to a lower futures price.
• Dow component Proctor & Gamble (PG) was either misquoted or mis-priced much lower than it should have been. (Cramer notices this on the video.)
• The market makers on the NYSE shut down for a few minutes to pause and reflect on the day’s previous 3% fall in prices. This sent existing sell order to smaller exchanges which couldn’t find enough buyers and thus prices fell dramatically.

I bet you thought that was it. But wait there’s more!

• There were fears over the European sovereign debt crisis and the crashing Euro.
• Related to the European crisis were images on TV of Greek citizens rioting because of the new fiscal austerity measures placed upon them.
• Computers trading with each other in fractions of a second all simultaneously decided to sell (similar to the October 1987 market crash). This isn’t so improbable as you might expect, because most of those system’s algorithms (“algos”) were programmed by a similar set of computer and math genius who went to similar schools and were taught similar economic and financial theories.
• And finally, my favorite: The whole affair could have been orchestrated by TPTB (The Powers That Be) on Wall Street to fleece profits from the masses (triggering stop loss orders at low prices) AND scare Washington into diluting the Financial Reform Bill being debated on Capital Hill that very day.

Here’s what should bother and scare us:

First, no one knows what caused the crash.

Second, an incredible amount of wealth, greater than some nations’ GDP, vanished into thin air over 15 minutes. How safe and secure should we feel?

There are even other possible issues which could have caused this crash and they should cause us to thoroughly examine and rebuild our financial system to be better able to absorb shocks.

Perhaps we’ll find that, like most catastrophes, it was a combination of errors and systemic issues that caused the 10% intraday stock market plunge. The stock market could handle and has handled issues in the past of similar magnitude to those listed above. However, if a few of these occurred during one day, it is doubtful order could be maintained with the current systems in place.

P.S. Does anyone still believe in the efficient market hypothesis and that stocks are ALWAYS perfectly valued?

How about the theory that “there is a buyer at every price point?”

Warren Buffett calls derivatives “financial weapons of mass destruction.”  Do you believe him?

Derivatives are financial instruments whose prices are derived from underlying assets.  One example would be a futures contract between a farmer and a food processor.  In this case the underlying asset is the grain harvested by the farmer and the derivative is the contract to deliver that grain at a specified price, time, and location.

This all sounds reasonable enough.  So why would Warren Buffett call derivatives “financial weapons of mass destruction”?

What if a Wall Street trader could make financial bets that rewarded the trader with bonuses and the firm with earnings all without setting aside capital or assets to cover that bet?  How many of those bets would you make?  How many would you make when you get immediately rewarded for wins and little or no apparent penalty for losses in the unforeseeable future?  Finally, how many would you make when your expert with a PhD from MIT says his mathematical model shows those bets are risk free?

Now that you’ve thought about those questions, watch this video from Khan Academy regarding Credit Default Swaps (CDS).   Listen for the part about a cascading failure which starts in one location and ripples through the whole system, ultimately destroying everything that looked seemingly safe and sound.

Khan Academy – Credit Default Swaps 2