December 11, 2018
This past week, the extreme level of market volatility painted a pretty clear picture of some glaring flaws in both the Fed’s fiscal policy and the way the SEC is loosely allowing the stock market to rapidly morph into a financial “Wild West.” The top news story circulating after Friday’s close was an interview with JP Morgan’s quantitative analyst Marko Kolanovic, who said, “we trace the disconnect between negative sentiment and macroeconomic reality to the reinforcing feedback loop of real and fake negative news.”
Kolanovic cited a combination of domestic political groups, analysts and foreign actors who are amplifying negative headlines to sow discord and erode faith in markets. There are ‘specialized websites’ that present a blend of real and fake news and distorted write-ups of financial research, he said, without citing the specific sites. “If we add to this an increased number of algorithms that trade based on posts and headlines, the impact on price action and investor psychology can be significant,” Kolanovic said.
Let’s assume that Mr. Kolanovic is right and this activity has been going on for months, if not years. Has anyone – or any regulatory body (especially the SEC) – intervened and come up with any legal solution to counter this wretched phenomenon? No. And why not? I don’t have the answer to that question. While everyone is creating these headline/key word forms of algorithm-induced manipulation that incite high-frequency front-running, there is no mention from the “smartest guys in the room” of what to do about it.
While one pundit and portfolio manager after another is trotted out onto CNBC, Bloomberg or Fox Business News to openly complain about this dilemma, they offer no remedies, and yet they remain fully invested, as if this problem will somehow disappear into thin air. It’s a bit surreal and naïve to surmise that somehow, rational and logical thinking will be restored to bridge the “yawning chasm between the real U.S. economy and how markets are behaving”, as Mr. Kolanovic so correctly put it.
If short-sellers and high-frequency front-running proprietary trading firms are raking in hundreds of millions of dollars from this activity, why would they stop this market manipulation now, when there are no checks or plans of any checks to be put into place? Hedge fund manager Leon Cooperman gave an interview last Thursday on CNBC where he called for the re-instatement of the Uptick Rule, which was eliminated in July 2007 – right before the S&P plunged 35% in 2008, with short-sellers leading the way.
The Uptick Rule was put in place with the S.E.C. Act of 1933 & 1934. It was enacted to prevent “bear-raids” on stocks. Syndicates could sell a stock short and continue selling it, thereby driving it down in price. This helped cause the Crash of 1929. The Uptick Rule stopped the bear-raids. However, the Uptick Rule was repealed in 2007. This is part of the reason we have seen “mini flash-crashes” in stocks recently.
The SEC’s Office of Economic Analysis established a pilot program in 2004 to determine whether the Uptick Rule was still effective. In doing so, it suspended the Uptick Rule for one-third of the stocks in the Russell 3000 Index while maintaining the rule for the remainder of the stocks. In so doing, it was able to compare results from two groups of securities under identical market conditions.
Results from that pilot program demonstrated that although the elimination of the Uptick Rule increased the volume of stocks shorted, it did not increase the overall short interest in a security. And since the interest in shorting a particular security remained undiminished, the study concluded that the Uptick Rule had no real ultimate impact. Following the results of this study, the Uptick Rule was repealed in 2007.
The SEC concluded that,“The general consensus from these analyses and the roundtable was that the Commission should remove price test restrictions because they modestly reduce liquidity and do not appear necessary to prevent manipulation.” For 2004, the Russell 3000 gained 10.4%, meaning that this study was conducted in a rising market and was thereby not stress-tested during a declining market.
Since the elimination of the Uptick Rule and the subsequent financial crisis of 2008-2009, and several flash crashes since then, Wall Street veteran Muriel Siebert, former SEC Chairman Christopher Cox, former Senator John McCain and former Fed Chair Ben Bernanke have all argued to restore the Uptick Rule. On January 20, 2009, Congressman Gary Ackerman (D-NY) received a letter from Chairman Cox—written the day he left the SEC—in which Cox said he supports the reinstatement of an uptick rule.
The 2009 letter read:
“I have been interested in proposing an updated uptick rule. However, as you know, the SEC is a commission of five members. Throughout 2008 there was not a majority interested in reconsidering the 2007 decision to repeal the uptick rule, or in proposing some modernized variant of it. I sincerely hope that the commission, in the year ahead, continues to reassess this issue in light of the extraordinary market events of the last several months, with a view to implementing a modernized version of the uptick rule.”
That was nearly 10 years ago and here we are today dealing with wild market gyrations with no guardrails in place. Fake news can’t be fixed, but much can be done to fix the volatility born of algorithmic trading.
History is Not on the Side of the Fed
My other great concern, while not a certainty, is that even if the Fed were to pause their planned policy course and stop raising rates, they cannot undo the economic damage that they may have already done. Monetary policy errors are never obvious when they are made, but they emerge with the passage of time.
Historically, there is a lag period of between 8 to 12 months of when an interest rate hike takes place and when its effects upon the overall economy are fully felt. Therefore, of the Federal Reserve’s eight rate increases during the current tightening cycle, the cumulative economic impact of the last four have yet to be fully measured. For investors, these potential policy miscalculations have unwittingly and significantly increased the perceptive risk of a recession within the next year and a half.
The current investment outlook will remain very fluid, as there is the very real possibility that positive developments and events could be either realized or achieved before year end. Any resolution of the ongoing trade and tariff dispute with China, or a signal from our central bank that there could be a pause in their planned rate hikes, would easily trigger a significant and broad-based market rally.
While it is always easy to paint any investment outlook with the broad-brush stroke of being overly positive or negative, the reality of how and where we choose to invest is actually much more nuanced. Prudently navigating this ever-changing economic landscape is the byproduct of the Fed’s monetary policy, which is to promote maximum employment (done), stable prices (done) and moderate long-term interest rates (done). As Dallas Fed President Robert Kaplan stated last Thursday, “one of the key tools we have at the Central Bank is patience, and I think we ought to be using that tool.”
The best outcome the market can hope for is for the FOMC meeting on December 18-19 to be brief and accommodative. Based on the full interview Mr. Kaplan gave to CNBC economist Steve Liesman, it’s not by any means too late to do nothing next week. And nothing is exactly what they should do.