Crosscurrents July 20/05
July 20/05
by Alan M. Newman
Are studied perceptions of value at all possible when Program Trading encompasses as much as two-thirds of all trading on the New York Stock Exchange? Over the last six weeks, programs have surged to 62.1% of all NYSE volume, as the “rebalancing” of several major indexes took place, including the Russell and S&P. In these maneuvers, certain stocks must be sold and other purchased to more effectively represent the actual index. During the week of June 24th, a daily average of 1.34 billion shares were traded on the NYSE to achieve the desired mix, more than three-quarters of all shares traded! Not one of these programmed shares were traded on the basis of value. What the share might be worth according to the company’s prospects was simply not a part of the “decision” making process. Such trading might not be a concern if limited to a very small fraction of overall share volume, but with programs now accounting for close to 60% of all NYSE volume, it is clear that whatever transactions are catalyzed by judicious analysis of company prospects, far more are not subject to analytical scrutiny.
We do not believe stocks are fairly valued, simply
because most are traded without regard to value. The current environment
is unique in history and is worsening. The small investor is rapidly
disappearing as a factor in determining how much stocks are worth.
Instead, indexing and mechanical procedures have overwhelmed the arena.
The NYSE is quite happy with the results, since the business generated
by programs is clearly counterbalancing the losses from traditional trading.
The trend in program trading is rising rapidly. The trend in non-program
trading is falling rapidly.
Does “algorithmic” trading really add anything to the
efficiency of prices? According to Mike Santoli’s piece in Barron’s
over a year ago, “The use of statistical formulas [determines] which stocks
to trade, when to trade them, and at what price. Big securities firms
are making aggressive use of this approach and sharing their systems with
institutional clients.” It’s all about generating business and commissions.
But the more commissions dwindle, the more volume must be generated.
Add in “statistical” and “index” arbitrage and the massive trading of
exchange traded funds and it is clear that only volume counts, not investors
and not prices. So what about the bubble in Program Trading?!
Despite the modest new highs achieved last week, our
forecast of continued extremely low volatility has been right on.
But finally, finally, after many months of waiting patiently, that should
all change quite soon. The way we see it, a major top is rapidly
forming.
In our last issue we said, “….extremely strong
resistance at SPX 1229 should hold all further rally attempts…”
So far, so good. Friday’s print high was SPX 1229.53, less than
half a point above the March 9th high. But why are we expecting
a top? Check out the charts on page four again. Way too much
effort is being expended for modest price gains. Once the market
falters, we expect the downside to unfold far more quickly than anyone
is prepared for. Although we have acquired a modicum of doubt about
our autumn downside target of Dow 8500, a 15% to 20% correction at this
juncture is clearly possible.
The good news is that we are fairly confident that the Fed’s final rate hike will come in August, if it comes at all. The bad news is why. Delta’s recent huge fare hike of $100 will undoubtedly be followed by all the major carriers and should impact travel accordingly. Thus far, $60 per barrel oil has not had any visible effect upon the economy. It will and soon. We expect economic activity to suffer and the signs should soon appear. Perhaps not a recession but any economic slowdown will be a distinct negative for the stock market. With emotions now running near optimistic extremes and fund cash ratios near record lows, there is no room for error at all!
Can prices move still higher? Perhaps very modestly. And perhaps another few weeks will elapse before the downside gets going in earnest.
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As the first half of the year closed out, the Investment Company Institute reported how mutual funds fared for the month of May. Inflows remained modestly positive at $11.2 billion, up 30% from April but still down 26% from March. Through the first five months of the year, inflows totaled $67.1 billion, down 38.2% from the same period a year earlier. Interestingly, in the 17 months since the end of 2003, inflows have totaled a huge $245.7 billion and have bought almost no price improvement with the Dow gaining only 1.8%. Fancy that. A quarter of a trillion bucks buys almost nothing. And the media are only worried about housing prices?!
The bigger news is that the cash-to-assets ratio is
now down to 4.1%, the lowest reading since the peak of the mania, when
the ratio plunged to 4.02% in March 2000. The May level is the second
lowest over the life of our chart and the 12-month moving average of the
mutual fund cash-to-assets ratio is now down to another record low of
4.29%. There is no doubt that indexing in all its many forms, especially
Exchange Traded Funds, have contributed to this phenomenon as active money
managers spend literally every penny coming in (and more) since interest
on cash generally cannot compete with a rising stock market.
As well, absolute cash levels are anything
but robust. At the end of February 2000, just days before the manic
peak, total mutual fund cash was $186.7 billion. By October, cash
levels had reached $256.7 billion, still insufficient to prevent much
lower prices. But by the arrival of 2002, mutuals began spending
down cash rapidly to support prices. By the end of February 2003,
just days before an important bottom, cash had dwindled to only $109.1
billion. Absolute cash levels are now $180.7 billion, way too close
to the levels reported in February and March of 2000 for investors to
take comfort.
It is now estimated that three-quarters of all inflows are going into ETFs, a telling factor in our analysis that we remain in the midst of a mania. Prices for individual stock issues are no longer relevant—it is only the various and sundry indexes that count. In such an environment, there cannot be any assumptions that constituent issues are fairly valued, thus there can be no assumptions that the index itself is fairly valued. The stock market has become a game where indexing and other games totally govern prices, rather than a capital market based upon studied perceptions of value. None of this rates even a few lines in the evening press, which is now fully devoted to nothing other than the housing bubble. Incredible.
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ABOUT ALAN M. NEWMAN
Alan M. Newman has been the Editor of CROSSCURRENTS since the first issue was published in May of 1990. Mr. Newman is also a member of the Market Technician's Association and has been widely quoted for years by the financial press, media, and other newsletters and has written articles for BARRON'S.
The newsletter is published 22 times per year and focuses on economic and stock market commentary, often covering controversial subjects. Several proprietary technical indicators are usually featured in every issue accompanied by current interpretation. Broad samples of our work can be viewed at http://www.cross-currents.net/.
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