Tuesday, July 30, 2013

HFT and the Flash Crash

Boyle and McDougall’s hedge fund doesn’t do high frequency trades, so to find out more I meet Simon Jones, who was running the quants desk at a major bank up until a few months ago. He is 36 years old.

“The guys and women who worked with me were the best of the best. They came from all over the world: from India, Russia and China.” The job was intense and highly competitive. “Let’s say I have noticed that the moment the Dow goes up the FTSE goes up,” says Jones. “The first person to notice that and make a trade can make money but to do that means getting the data from New York to London and then getting my trading decision across the Atlantic and me buying my FTSE before anyone else does.”

In this game speed is critical and that has led to what has been dubbed an arms race between firms. It has got to a point where firms have actually started moving their servers nearer to an exchange to speed up connection times.

In 2010, a company called Spread Networks laid a new direct cable between New York and Chicago, going straight through the Allegheny mountains, which shaved a little bit more than 1,000th of a second off the transmission time between stock exchanges.

For the opportunity to use a similarly fast tube between New York and London, Jones’s old bank was asked to pay $50 million. “It would have given us an advantage over others of about a six thousandths of one second,” says Jones.

This focus on the shortest of short-term gains has vastly increased volatility. “Warren Buffett owns shares in Coca-Cola and when they go down he says 'I’m holding on to them because I think they will go back up’,” says Jones. “But the HFT guy, all he cares about is the next millisecond. And when too many people start panicking about the next millisecond that’s when you have a crash.”

The perfect example of such a crash took place on May 6 2010. So many shares were traded that day that the online trading section of the New York Stock Exchange temporarily froze and between 2.30pm and 3pm the Dow Jones lost and then regained nearly $1 trillion. In what became known as the “Flash Crash”, shares in the management consultancy firm Accenture plummeted to a fraction above zero . Apple shares went up to $100,000.

“None of us knew what to do or what would happen next,” says Dave Lauer, a quant who was working on a HFT desk that day. “It was terrifying.”

For Lauer, the Flash Crash was a wake-up call. “I started to see how the race to be fastest had left things in a very fragile state,” he tells me. The following year his wife revealed she was pregnant which prompted him to make a big decision. “I remember thinking, 'How will I explain to my future child what I do for a living?’” Lauer quit his job and last year told the Senate Banking committee that High Frequency Trading had brought the market to crisis point.

The Flash Crash was partly caused by the HFT strategy of “spoofing”; making bogus offers to buy or sell shares to flush out the intentions of rivals. On the day, an astonishing 19.4 billion shares were traded, more than were traded in the entirety of the Sixties, but hundreds of millions of them were never actually sold; they were merely held for a few thousandths of a second as traders tested the waters.

Isn’t there something wrong with a system that promotes so much volatility to the benefit of no one except a handful of hedge funds? Can it be a meaningful investment of time and technology? Warren Buffett’s business partner, Charlie Munger, has described High Frequency Trading as “basically evil”. “I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short-term people trying to get information one millionth of a nanosecond ahead of somebody else,” he said earlier this year. “It’s legalised front-running.” HFT is certainly of no clear benefit to everyday investors - savers in pension funds and life policies.

The quants I meet don’t believe what they do is necessarily dangerous but they do voice some doubts.

“Some of the guys who come from pure science and maths backgrounds are used to solving a problem and it works,” Patrick Boyle says. “They think they can find a formula that will perfectly describe how the market moves. That is the philosopher’s stone – it is utterly impossible.”

[via ScaleNet]

Jim Simons, the most famous quant of all

Since the 1969 moon landing, the American government had cut funding for science programmes and diverted it to the war in Vietnam.

“A generation of physicists who had gone to graduate school left with their PhDs and entered a severely depressed job market,” explains James Owen Weatherall, author of The Physics of Finance. They had to earn a living somehow, and, seeing how much money that there was to be made on Wall Street, many decided to move into finance.

In Britain, the fall of the Soviet Union led to an influx of Warsaw Pact scientists. In both cases, these scientists brought with them a new methodology based on analysing data and also a faith that, using sufficient computing firepower, it was possible to predict the market. It was the start of a new discipline, quantitative analysis, and the most famous “quant” of all was a shambling donnish maths genius with a scraggly beard and aversion to socks called Jim Simons.

For those who know their physics, Simons is a living legend. A piece of mathematics he co-created, the Chern-Simons 3-form, is one of the most important elements of string theory, the so-called “theory of everything”. Highly academic, Simons never seemed the sort of person who would gravitate to the earthy environs of Wall Street. But in 1982, he founded an extraordinarily successful hedge fund management company, Renaissance Technologies, whose signature fund, Medallion, went on to earn an incredible 2,478.6 per cent return in its first 10 years, way above every other hedge fund on the planet, including George Soros’s Quantum Fund.

Its success, based on a highly complex and secretive algorithm, continued in the Noughties and over the lifetime of the fund, Medallion’s returns have averaged 40 per cent a year, making Simons one of the richest men in the world with a net worth in excess of $10 billion.

Of his 200 employees, ensconced in a fortress-like building in unfashionable Long Island, New York, a third have PhDs, not in finance, but in fields like physics, mathematics and statistics. Renaissance has been called “the best physics and mathematics department in the world” and, according to Weatherall, “avoids hiring anyone with even the slightest whiff of Wall Street bona fides. PhDs in finance need not apply; nor should traders who got their start at traditional investment banks or even other hedge funds. The secret to Simons’s success has been steering clear of the financial experts.”

Thursday, July 18, 2013

Detroit files for bankruptcy

The city of Detroit filed for federal bankruptcy protection on Thursday afternoon, making the automobile capital and one-time music powerhouse the country's largest-ever municipal bankruptcy case.

  The case filed in U.S. District Court for the Eastern District of Michigan came after Kevyn Orr, the emergency manager, failed to reach agreements with enough of the bondholders, pension funds and other creditors to restructure Detroit's debt outside of court. The final decision rested with Republican Gov. Rick Snyder, who had appointed Mr. Orr as Detroit's overseer in March.

It was expected that the city would report long-term liabilities close to $20 billion. The city's assets were less clear, but Mr. Orr had called the city functionally insolvent and recently missed a payment to the city's pension system of nearly $40 million.

The financial outlook has never been bleaker for the Motor City, which has shrunk from its peak of nearly two million people in 1950 to 700,000 today.

[wonder if the market will go down tomorrow now]

Tuesday, July 16, 2013

budget deficit shrinking

Here is a story still under-told. The US federal budget deficit is plunging. It's been in a steady decline for over four years; but the pace at which it's improving has really picked up in the past year, particularly last month. About two-thirds of the improvement has come from the spending side, with the remainder on the revenue (tax receipts) side.


 I suppose that's good relatively speaking, but only in comparison.  It's not that 700 billion in the hole (per year) is good.  It just that it was so horrendously bad at 1.5 trillion in 2010. I guess that's what fighting two wars will do.

I see we were running a surplace in the late 1990's/early 2000's.  I wonder who was president then, in sayy 1998 through 2002.

Let's see.  According to wikipedia, Bill Clinton served from 1993-2001.  That's when the deficit went from negative to positve.  Then George W. Bush from 2001-2009.  And the bottom fell out.  (Bush gets blamed for everything.)  Coincidence of course.

Monday, July 15, 2013

the 1%?

The Koch brothers can get left-leaning Americans' blood boiling just by drawing breath. Imagine the rage when they actually poke the bear a bit.

In its continued bid to leave its liberal counterparts as red-faced, flustered and hyperventilated as George Soros leaves his conservative detractors, the Charles Koch Foundation recently released a commercial that suggests an annual income of $34,000 puts a worker among the wealthiest 1% -- in the world.

The basic premise is that Americans don't need things like food stamps or the minimum wage to help them, because they're already so much better off than poor people in the world around them. The Economic Policy Institute can't help but disagree. Its Family Budget Calculator notes that a family of three would require an income of $45,000 a year to cover basic needs in Simpson County, Miss., the U.S. region with the lowest cost of living for a family of that size.

Bloomberg puts Charles Koch's wealth alone at $43.4 billion. His brother and Koch Industries partner, David, is worth just as much. While that might jaundice their view of what a person on minimum wage needs to survive, Charles Koch insisted to the Wichita Eagle last week that the minimum wage is just one of the items that need to be removed:

We want to do a better job of raising up the disadvantaged and the poorest in this country, rather than saying, "Oh, we're just fine now." We're not saying that at all. What we're saying is we need to analyze all these additional policies, these subsidies, this cronyism, this avalanche of regulations, all these things that are creating a culture of dependency. And like permitting, to start a business, in many cities, to drive a taxicab, to become a hairdresser. Anything that people with limited capital can do to raise themselves up, they keep throwing obstacles in their way. And so we've got to clear those out. Or the minimum wage. Or anything that reduces the mobility of labor.

In Koch's view, these factors put the hurt on "economic freedom." His ad cites a report from the Koch-funded Fraser Institute showing that the "United States used to be a world leader in economic freedom but our ranking fell. And it's projected to decline even further."

Monday, July 08, 2013

predicting the future (is what people want)

Carl Richards writes about our abysmal ability to predict the future:
Forecasts about the future of the market are very likely to be wrong, and we don't know by how much and in which direction. So why would we use these guesses to make incredibly important decisions about our money?

Jason Zweig tries to save investors from themselves:
And while people need good advice, what they want is advice that sounds good. 
The advice that sounds the best in the short run is always the most dangerous in the long run. Everyone wants the secret, the key, the roadmap to the primrose path that leads to El Dorado: the magical low-risk, high-return investment that can double your money in no time. Everyone wants to chase the returns of whatever has been hottest and to shun whatever has gone cold. Most financial journalism, like most of Wall Street itself, is dedicated to a basic principle of marketing: When the ducks quack, feed 'em.

Eddy Elfenbein writes on the amazing growth of dividends in the S&P 500 (SNPINDEX: ^GSPC  ) :
S&P reported that dividends for the S&P 500 grew by 15.49% in the second quarter. This was the tenth-straight quarter in which dividends have risen by more than 12%. 
This is especially impressive because it comes after the dividend surge from Q4 when dividends rose by 22.77% in an effort to beat higher taxes. 
For Q2, the S&P 500 paid out index adjusted dividends of $8.61. Think of it this way: The S&P 500 is currently about 1,625. Every month, it pays out about three points' worth of dividends. For all of 2013, the dividends paid out will be roughly double what was paid out ten years ago.

The Wall Street Journal writes about what falling gold prices are doing to gold miners:
On top of falling metals prices, miners face rising costs. The cost of mining an ounce of gold rose to $775 in 2012 from $280 in 2005, according to BMO. That has left many miners spending more money than they are earning. The shortfall was addressed by raising funds with bonds and shares, but those markets are getting increasingly harder to access.

and four more

Monday, July 01, 2013

Mitch Zacks on interest rates and the stock market

Fluctuations in interest rates will remain center stage in the second half of 2013. Usually, the ten-year treasury yield should be about 200 basis points, or 2%, above the inflation rate. Right now, as of the end of June, the ten-year treasury is yielding 2.5%. The problem is that inflation is not even close to 0.5%. Most likely, depending on how it is calculated, core inflation is running around 1.1% annually and projected to rise to around 1.5% in the third quarter of 2013. This is below the Federal Reserve’s target of 2% and is also substantially below the average inflation rate we have seen in the U.S. The current low inflation rate implies that the ten-year treasury should be over 3%. The reason the ten-year rate is not that high is because the Federal Reserve is buying $85 billion dollars of treasuries and mortgage backed securities each month in order to artificially keep interest rates low.

From 1914 through 2013 annual inflation has averaged 3.35% in the U.S. This implies that when the economy returns to normal, the yield on ten-year bonds are likely to at least double from 2.5% to 5%. The 5% number is arrived at by estimating that inflation will return to historical norms of 3% and, in the absence of bond buying by the Federal Reserve, the ten-year treasury will price itself so it yields around 2% above the inflation rate.

If we estimate that the yield on a ten-year treasury will increase from 2.5% to 5% over a three year period, this implies that ten-year bond prices will fall roughly 23% over this three year period. Effectively, if inflation returns to historic levels and the Federal Reserve stops its bond buying, investors holding treasuries are going to have their heads handed to them.

Right now the stock market is unfortunately in a damned if you do, damned if you don’t, state. If the economy recovers stronger than expected, it will likely cause some inflation and the Federal Reserve will be forced to taper their bond buying sooner than expected. This would be a negative for the market. If however, the economy weakens substantially, earnings estimates will be pulled back and the market will sell-off.

To head higher, what the stock market really needs is an economy that is neither too weak, nor too strong. If we see such a goldilocks type of economy, the stock market will continue to benefit from improving earnings due to a growing economy and lower interest rates due to the continued easing by the Federal Reserve. It is starting to look like a narrower and narrower band that economic growth must materialize in for the market to continue at the rate it has in the first half of the year.

As a result, the probability of disappointment is growing and I would not be surprised to see some selling in the second half of the year. At the end of the day, the right course of action is to keep your eye on the long-term and ignore the quarterly, or even yearly, fluctuations in the market. Thus, for the investor with the time horizon of several years, a market pull-back represents a buying opportunity.

While we are likely going to see some volatility and selling in the immediate future, the key is to make sure you are positioned so that despite pullbacks, you can continue to hold equities. Over the long-run, these quarterly fluctuations in the market that we spend so much time worrying and analyzing about, really amount to noise. The key, as always, to making money in the stock market is to be able to hold stocks for a long period of time and not to overreact to market fluctuations.

[Mitch Zacks runs the Zacks Small-Cap Core Fund (ZSCCX) which has an annual turnover of 173%]