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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 2-Jul-2009
The influence of computerized trading programs

Web Log - July, 2009

The influence of computerized trading programs

It may be that computer software is already in charge of our futures.

In 2005, I posted an article called "A new mystery: Why is the P/E ratio remaining constant?" I noticed that the S&P 500 price/earnings ratio had remained almost constant for over a year, something that had not occurred in the previous century or more.

In that article I described something called the "Fed Model," a simple trading algorithm which, I understood, was widely followed by many traders and financial institutions. The Fed Model was based on a 1997 Federal Reserve report that related price/earnings ratios to changes in long-term Treasury yields. I inferred from the evidence that most traders and financial institutions were all following the same buy/sell strategies based on P/E ratios, as a result of which the P/E ratio was remaining constant.

If you look at the bottom of the home page of this web site, you'll see the price/earnings ratio chart that gets updated every week. Here's last Friday's version of the chart:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 26-June-2009. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 26-June-2009. (Source: MarketGauge ® by DataView, LLC)

As you can see from this chart, the mystery of the constant P/E ratio continued long after 2005. The P/E ratio was in the 18-20 range for years, starting in 2004. This happened despite the fact that the S&P index was going up and down (mostly up). This behavior was interrupted for a few months in 2008, and was abandoned completely in 2009.

I've written about this a number of times since 2005. My conclusion was that the only way that this could be happening was if programmed trading algorithms at different financial institutions were very similar to one another.

Speaking as a software development consultant, I've worked at a number of financial institutions, and I know that programmers tend to move from one company to another over time. Thus, it's not surprising at all that the trading algorithms at different financial institutions were similar to one another. So I'm not saying that there was any conspiracy. I'm simply saying that the trading algorithms were and are common knowledge across the industry, so different institutions are likely to implement roughly the same algorithm. And it seems clear that a P/E valuation of 18-20 has been a part of those common algorithms.

But it's clear from the above chart that something changed early this year, as I wrote two months ago in "Stock market rally raises cautious, anxious hope among investors."

The change was triggered by fourth quarter earnings last year -- which were negative. This caused the P/E ratio index to shoot up to 60. This led to a lot of lying and prevarication in the financial media.

(See "Wall Street Journal and Birinyi Associates are lying about P/E ratios" and "Laszlo Birinyi provides insight on his fantasy price/earnings computations." The Wall Street Journal recently completely reversed its policy, as I described in "Wall Street Journal sharply revises its fantasy price/earnings computations.")

This lying about P/E ratios should be major industry news, but I've never seen anything about it in the mainstream media, nor in any of the financial blogs, including Nouriel Roubini's blog, Michael ("Mish") Shedlock's blog, the Calculated Risk blog, the Sudden Debt blog, the MinyanVille blog, Yves Smith's Naked Capitalism blog, and the Financial Times alphaville blog. I don't check all of these blogs every day, but as far as I know, this P/E ratio issue is never mentioned by any of them.

If you look at the "official" S&P 500 P/E index spreadsheet, you can see that the Q2 P/E is 133.62.

If you look at the latest WSJ chart, with its newly revised more "honest" reporting, then you see that the S&P 500 P/E index is 35.38.

But if you listened to Bloomberg TV today, then you heard "the P/E index is around 15, and there are many stocks with very low valuations." I have no idea where this figure of 15 comes from.

Mainstream financial reporting has gone completely off the rails. It's almost completely total nonsense, catering to brokers and investment bankers who make fat commissions and fees off of traders, and who don't want anyone rocking the boat by reporting a P/E ratio of even 20, let alone 133.

A new mystery

But we're still left with a mystery. What algorithms are the computerized buy/sell trading programs using today? They're obviously not pegging the algorithm to a P/E ratio of 18-20 any more; that's been thrown out. But what algorithms are they using?

The answer to the question was provided by an interview of Joe Saluzzi of Themis Trading on Bloomberg TV on Tuesday. The following is my transcript:

"I'm a realist. I like to cut through the garbage that we hear constantly from hopeful politicians and hopeful corporate executives, trying to tell you they see things are good.

Joe Saluzzi of Themis Trading <font face=Arial size=-2>(Source: Bloomberg TV)</font>
Joe Saluzzi of Themis Trading (Source: Bloomberg TV)

Let me see some numbers. Show me the quarterly earnings. Are you going to prove to me that second quarter was good, in the retailing sector when the savings rate is sky high, and consumers aren't spending?

No, I don't believe it. I'm a cynical person at heart, I guess, but I'm also a realist, and it keeps me out of trouble a lot. ...

The problem is that most people are pessimistic on this market right now, but they're afraid because they see the market running.

What my job is during the day is I'm an institutional trader for large mutual funds and hedges. So my job is to trade for them, and to not get caught upin the noise.

The volume that you see during the day, sometimes as high as 12 billion across all three exchanges, is fictitious. It's not real. I'm going to say that 60-70% of this volume that you see coming across -- it's volume, but it's done by what they call 'high frequency traders.'

These are machines. The biggest machine out there wins the game nowadays. And these people deal in sub-seconds. 50 milliseconds is a huge amount of time. Anything over that and you're a dinosaur in the business.

So what they do all day long is they buy and sell and they try to collect liquidity rebates from the exchanges, who basically in partnership with them, and they trade for no apparent fundamental reason, and this is my problem.

And being that we're all in a bullish tape right now, they're all just buying. ...

I trade for my clients. I'm an agency-only trader. My job -- they make the decisions, I execute around the noise. Some of the clients buy, some of them sell, we deal with all different types. Some short, and so on. Some are sector based.

But my job is to make sure -- that during the day when a program gets shot through, -- by the way, a billion shares a week going through certain broker on the exchange principally with programmed trades -- it's a way to get the market to go in your direction. And what happens is -- since we're all electronically linked, the algorithms that all these programs use, according to the guys that I talk to, chase the stocks and artificially inflate the prices.

It cuts both ways. Since we're in a bull tape, everyone is jumping on board, but here's the trick: They could run for the trap door tomorrow, and if everybody becomes a seller, they'll all just go the other way. They don't care about the prices any more."

According to Saluzzi, these computerized buy/sell programs are dominating the market these days.

But there's more -- a remarkable concept. What he's saying is that the computerized trading algorithms are essentially doing panic buying (though he doesn't use that phrase). He's saying that these trading programs are programmed to push stock prices up.

Once again, I'm not implying any conspiracy or collusion. Let me put on my computer programmer hat again. I've never had to implement an algorithm of this sort before, but I can imagine what kind of algorithm I'd implement if a client told me, "Assume that the market is going up, and program the computer to stay ahead of the market and make money." If I assume that the market is going up, then I'd program the computer to pursue a strategy that pays a little more as time goes on.

And now, once again, we know that computer programmers move from company to company, and we can conclude that all the financial institutions are implementing roughly similar algorithms.

There's a remarkable concept. We normally think of panic buying as based on human emotion, but Saluzzi is essentially saying that the computers are panic buying, pushing up the stock market prices.

This is a weird concept since, as we all know with absolutely certainty, computers are mechanical devices totally lacking in emotion.

Presumably then, the reason that computer programs "artificially inflate the prices" is because the programmers tweak the program parameters to do so.

However, Saluzzi points out that this won't go on forever. He says that there's a "trap door," and this could reverse very quickly.

If I were a computer programmer for such a client, I'd parametrize my software algorithms so that if my client suddenly said, "Assume that the market has stopped rising, and it's going to fall for a while," then my software would instantly change its strategy. Instead of panic buying, my software would be panic selling.

And so would everyone else's software algorithms.

So what I'm suggesting is this: The the computerized trading algorithms have changed drastically in the last year.

Since 2004, these algorithms have been pegged at maintaining a P/E ratio of 18-20. Obviously that's out the window now, as the P/E ratio is well above 100.

Is any other peg being used? I'm certainly not aware of anything.

This gives meaning to Saluzzi's statements: "And what happens is -- since we're all electronically linked, the algorithms that all these programs use, according to the guys that I talk to, chase the stocks and artificially inflate the prices."

In other words, the computerized trading algorithms are specifically designed to create a bubble. Once again, I'm not saying that this is a conspiracy, any more than the Tulipomania bubble was a conspiracy. I'm simply saying that the "human emotions" or "animal spirits" that normally cause a bubble have been encapsulated in computer algorithms and programs, resulting in computers that create bubbles.

As I've said for decades, "To err is human. To really screw things up takes a computer." And that seems to be where we are.

These computer programs make decisions in microseconds, far faster than human beings can react. In the 1929 stock market crash, it was human beings using the telephone to flood their stock brokers with sell orders that clogged the ticker tapes for hours.

What Saluzzi is telling us is that we're headed for a different kind of crash, where blindingly fast computers will be competing with each other to sell as quickly as possible.

As I've been saying for years, Generational Dynamics predicts that we're headed for a generational panic and crash, the first since 1929. Some people believe that the stock market has already crashed, but it hasn't been even close. Here's how I've described this several times in the past:

"A generational crash is an elemental force of nature, like a tsunami.

You'll have millions or even tens of millions of Boomers and Generation-Xers in countries around the world, never having seen anything like this before, not even believing it was possible, and in a state of total mass panic, trying to sell all at once. Computer systems will crash or will be clogged for hours, or perhaps even for a day or two. People who had hoped to get out just as the collapse is occurring will be totally screwed, and will lose everything. Brokers and other institutions will go bankrupt."

This might happen tomorrow, next week, next month or thereafter. We can't predict when it will happen, but it's coming soon with absolute certainty.

What Saluzzi's comments tell us is that the crash will be led more by computers than by humans.

(Comments: For reader comments, questions and discussion, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (2-Jul-2009) Permanent Link
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