October 30, 2018

October is home to the worst stock market crashes ever, including 1929 and 1987. Last week may also be remembered as one for the ages. It will go down in history as one of the more violent equity sell-offs we have seen in years. I have even heard comparisons to October of 2008. But what is really going on?

Algorithmic and High Frequency Trading (HFT) firms began selling a few weeks ago, when China’s sinking equity market led to a weak Monday (October 22) here. Selling pushed stocks down and blew out bid/offer spreads. Keep in mind, in a stable trading environment, tape spreads are a penny or less on liquid stocks. When liquidity is drained from the market and the order book is lopsided with sells, spreads can blow-out to 3-4 cents or more on less-liquid stocks. That translates to a 3 or 4+ standard deviation event skewed to the “profit” side of P&L ledgers for a High Frequency Trader. They make their money on spreads repeatedly throughout the day. I know one HFT trader personally who said, “We make our money for the year on days like this.” So, many days in a row “like this” for them means magnums of Cristal. They want volatility to explode and spreads to blow out. They will wait years for “days like this.”

I already mentioned that HFT algos parse news headlines for sentiment and they pay for order flow. Negative sentiment coupled with weak buying equals payday potential. Selling becomes aggressive and eventually pushes through technical sell levels for model managers.

What does all this mean?

The ETF industry has moved from management to asset gathering. With the explosion of ETF products from the 2000’s to now, RIAs and wire-houses made a concerted push to gather assets. Then they moved from in-house to outsourced “model management.” ETF model runners could be paid a percentage of assets gathered by the gatherers to run a strategy. These are often tactical and rule-based with technical floors built in. A stop based on low volatility means a relatively high price floor. When that gets breached by something like HFT firms pushing down prices – they must sell. The rules say so.

In the old days on the trade desk, someone would call me up and say – “J – I need a bid on $250 million of XYZ US midcap equity ETF.” I’d call my trader and get a bid based on where s/he could buy from the seller and comfortably hedge by selling the components (or an approximation-like futures). In fast markets, the spreads widened, and risk increased for dealers. Bids would go lower to try and maximize a reasonable spread (reward for taking risk). The real idea was to “try not to lose money.”

Eventually, this whole human-to-human process was replaced by machines running algos as automated market-makers. They too pay for order flow and base their market-making on some input for volatility and pressure one way or the other on the order book. When volume explodes, their bid/offer spreads reflect that. Once they are long from an equity ETF a model manager, they too must hedge. They employ algo-based sell programs for components of the correlated ETF. They sell stocks.

Eventually, levels are pushed low enough to get just about everyone freaked out. We move from a period of relatively widespread optimism (not to be confused with exuberance) to downright despair and pessimism in a few short weeks. When this mentality spreads to Main Street, the flush is nearly over.

The result is that defensive sectors are the only ones with their noses above water.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This Market is Now Seriously Oversold

All the while, I track my unusual institutional buying versus selling in a ratio. When the breadth dried up a few weeks ago, it said we should expect falling prices. When selling becomes extreme, it eventually hits a point that is unsustainable. That point was Friday morning: the buy/sell ratio plunged below 25%. The data I look at said it fell below 25% only three times prior in the past 6.5 years (1591 trading days).

In the last 6+ years, the ratio spent a total of 20 trading days (including Friday) below 25%:

  • 4 trading days October 15-20, 2014
  • 4 trading days September 24-29,2015
  • 11 trading days February 2-17, 2016

In these three instances, the average days spent below 25% is 6.3 trading days. This is my expectation for the current event, but with extreme levels of selling we could spend more time below 25%. The important thing is the average return of the Russell 2000 (IWM) is positive 2-8 weeks after the ratio first breached below 25%. That’s why I firmly believe the bottom is here and I expect a market bounce soon.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This sell-off started technically by a sudden absence of buying coupled with negative sentiment. My data tells me we are pretty much done. What astonishes me (but shouldn’t) is the rapidity from which we went from “good vibes” to “throw yourself out the window.” The emotional pendulum swung swift and hard.

But again, logic tells me the bull is still alive. At risk of being redundant, I cite record low taxes, record sales and earnings growth, record profits, and a strong dollar helping domestic mid and small cap margins. The 10-Year Treasury yielding roughly 3.08 is taxed at ordinary income rates. The S&P 500 currently yields just south of 2% and is taxed at long-term-capital-gains rates. Money invested in Treasuries offers only a slightly better after-tax return than U.S. equities while offering little potential for capital gains. I think yields aren’t compelling over equities until the 5% range, which is arguably still a long time away.

China’s equity market is volatile. Latin America is very volatile. Europe is facing its own headwinds. Commodities may offer a haven, but we haven’t hit the phase of the bull market that gets me excited about energy and financials. These stocks should see a resurgence when tech and consumer run their course. Not only are we not there yet, but tech and consumer companies are still churning out phenomenal numbers – even if they don’t always meet expectations. There is measurable growth and profitability. A slowdown has not revealed itself anywhere other than the market’s expectation of future prices.

It is important to survey data beyond emotion. The stock market can be both – a Jekyll-Hyde scenario. Right now, we see Mr. Hyde. Remember though, the sell button is pushed more frequently by emotion than by logic. With an oversold market by many metrics, including my own, fundamental strength we haven’t seen in years and unappealing alternatives in the investment landscape, I have to remain bullish on U.S. equities. This sell-off began technically and exploded into an emotional unwinding. Pessimism is everywhere. Doubt, fear, and anxiety can literally be felt in the air. That’s when you want to be bullish.

And I am.

Jesse Livermore had it right: “A stock operator has to fight a lot of expensive enemies within himself.”

About The Author

Jason Bodner
MARKETMAIL EDITOR FOR SECTOR SPOTLIGHT

Jason Bodner writes Sector Spotlight in the weekly Marketmail publication and has authored several white papers for the company. He is also Co-Founder of Macro Analytics for Professionals which produces proprietary equity accumulation/distribution research for its clients. Previously, Mr. Bodner served as Director of European Equity Derivatives for Cantor Fitzgerald Europe in London, then moved to the role of Head of Equity Derivatives North America for the same company in New York. He also served as S.V.P. Equity Derivatives for Jefferies, LLC. He received a B.S. in business administration in 1996, with honors, from Skidmore College as a member of the Periclean Honors Society. *All content of “Sector Spotlight” represents the opinion of Jason Bodner*

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