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Mark's Market Blog

10-11-09: Inflation, Food, Flash Trading

By Mark Lawrence

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The last weekend I traveled to a wedding, hence the blog being late this week. Next weekend I'm taking one of my sons to the Packers / Lions game, so again my blog will almost certainly be late. I hate to keep you in suspense, so I'll give you a taste of next week's blog today: "The market opened the week on Columbus day to very light trading and an unconvincing rise, then spent the rest of the week declining a bit as 3rd quarter results came in not quite as good as hoped for. The decline was lead by financial stocks."

As I predicted a week ago, the market went up a bit last week. There's something interesting to see in last week's chart: at the bottom is volume, the number of shares traded. Note that as the market raises lately the volume drops. Skepticism in this market is growing.

S&P 500 March 6 2009 to October 10 2009

Obama got the Nobel Peace Prize. I have now asked perhaps a hundred people their views on this (remember, I spent a few hours in airports this weekend), and by far the most common response is "What has he done?"

Terrorist attacks are growing in Pakistan, bringing that nuclear power ever closer to political collapse. Hillary Clinton felt it necessary last week to say in a press conference that we have complete confidence in Pakistan's nuclear security. I would feel confident if I knew there was a plan in place for the US to evacuate the Pakistani nukes under certain conditions.

Your car implies more about your life than you might think. While 13% of Chevy owners don't use the Web, by contrast, less than 3% of Honda owners remain in the technological Stone Age. The antithesis of flashy, Honda owners are usually pragmatic and well educated; 70% boast a college degree or higher, compared with 71% of Lexus owners, 60% of Toyota owners, 45% of Ford owners and 35% of Chevy owners.

Jim Rogers, a rather famous commodity trader, says world-wide inflation is inevitable. Asked if he foresees a 1970s-style stagflation period ahead, Rogers chuckled and gave an ominous reply: "I hope it's that good. It might be much, much worse. The Federal Reserve has laid the groundwork for some serious inflation down the road by printing all this money. So have many other central banks." Rogers says there are growing massive deficits in metals and food supplies. "A catastrophe is looming," he says. "The world is going to have a period when we cannot get food at any price in some parts of the world." These shortages in basic commodities and the current wide spread printing of money guarantee inflation at some point. He also says the idea that in the future anyone will be willing to lend money to the US government for 30 years in US dollars at 3%, 4%, 5%, 6% is inconceivable.

Rogers is "worried about the fact the U.S. government is printing huge amounts, spending gigantic amounts of money it doesn't have. People are very worried [and] skeptical about paper money [and] looking for places to protect themselves. The best way is to buy real assets. [That] has always protected one during currency turmoil, and it will again."

Where will these food shortages be? This is surprisingly easy to predict. Recall a year ago when rice was rationed even here in the US - I was only allowed to buy one 25 pound sack at a time at Sam's club, and this when I drive twice a day past the California Farmer's Rice Cooperative. There were riots in the Philippines and serious problems in India and Africa as Thailand and Vietnam discussed forming a rice exporters cartel. We can expect this situation to return, but this time the buyers will be more numerous due to population increases, and their currency will be worth less due to poor government policies.

Global Electronic Trading Co. is tucked behind a nondescript door on the second floor of the Chicago Board of Trade's building. Getco, as the firm is known, currently buys and sells 15% of all the stocks traded in the U.S., ranking it among the likes of Goldman Sachs and Fidelity Investments. Getco was reportedly valued at $1 billion two years ago and is rumored to have earned roughly half as much as that in net profit last year alone.

Getco earns its outsize profits buying and selling securities up to thousands of times a second. This frenetic profession has come to be known as high-frequency trading or flash trading, and in recent months it has emerged as the hottest ticket on Wall Street. Even as financial markets collapsed last year, high-frequency traders collectively enjoyed $21 billion in gross profit. On the NYSE, daily volume surged 43% through June from a year earlier to 6.2 billion shares; high- frequency traders are believed to account for 50% to 70% of the activity and similar proportions in electronic futures and options markets.

In the process they have ushered in the most wrenching, and controversial, transition in the history of U.S. securities markets. For decades the New York Stock Exchange towered over U.S. equity trading, with its market share rarely dipping below 80%. A the real shakeup has come very recently at the hands of high-frequency traders and the band of scrappy exchanges that have popped up in their orbit. In the past two years they have collectively cut the share of equity volume controlled by the NYSE from 50% to 28%.

Getco's programmed their computers to offer quotes and execute trades more quickly than rivals. Then, when the market moves, to do it again. By posting bids and offers for the same securities simultaneously, they are able to scoop up a spread of a tenth or a hundredth of a penny per share thousands of times a day while limiting the capital at risk. What Getco gives up by capping its risk it makes up for in volume. The company currently trades an estimated 1.5 billion shares a day with 220 employees and offices in Chicago, New York, London and Singapore.

The final structural move that set the stage for the current electronic trading revolution was Regulation National Market System, put in place in 2005. Previously brokerages were obliged to offer clients the best possible execution of stock orders. But it was left up to each firm to determine whether "best" meant the fastest or at the most favorable price. That left brokerages plenty of wiggle room to match buy and sell orders internally and pocket the spread, or send them to exchanges that paid kickbacks for order flow. Under Reg NMS, by contrast, the SEC decreed that market orders be posted electronically and immediately executed at the best price available nationally. To Getco and its high-frequency brethren, Reg NMS was like catnip. Many began posting continuous two-sided quotes on hundreds of stocks. Some sought to arbitrage the tiny price spreads that existed at any given moment between buy and sell orders. Others, known as rebate traders, profited from payments offered by exchanges. Others sought price differences resulting from momentary time lags between exchanges.

Infinium Capital is the biggest market maker in natural gas futures and runs its computers in 100,000 square feet near the Chicago River. The core of its operation is 40 racks of servers overseen by quant traders who man up to a dozen screens each. Infinium's operation runs on a piece of the public electricity grid backed up by two separate power substations and 196,000 pounds of batteries. Not safe enough. Infinium is paying to install a 2 megawatt diesel generator just in case. Infinium taps into the CME Group's computers, housed on the same floor of a data center, via dedicated fiber-optic lines capable of transmitting up to 5,000 orders per second with a lag time of no more than 10 milliseconds. Infinium has other servers strategically situated near exchange computers in New Jersey, London and Singapore. In Chicago 6 square feet of space in the data center where the big exchanges also house their computers goes for $2,000 a month.

Some high-frequency traders are sending out 1,000 orders a second. In the span of the two minutes it typically takes to notice and rectify a trading system glitch, a careless trader could pump out 120,000 faulty orders. On a $20 stock that represents a $2.4 billion disaster. The next trading company meltdown will happen in a five-minute time period.

While many market centers have adapted to cater to high-frequency traders, dark pools have adapted to evade them. Seth Merrin founded Liquidnet in 1999 as a place where professional money managers can swap large blocks of stock anonymously. The goal of Liquidnet is to avoid tipping off the market, including high-frequency arbitragers, that a big order is in the market and moving prices. The firm already handles 61 million shares a day, and Merrin views himself as something of a crusader who is enabling mutual funds, pension plans and other investors to trade at the best possible prices.

High-frequency trading helps small investors by narrowing spreads and speeding execution. The same can't necessarily be said for flash orders. Market center Direct Edge uses them to give a small group of clients a one-tenth-of-a-second crack at orders before they get sent to other markets. The practice has been criticized for favoring insiders, and the Securities & Exchange Commission may ban flash orders.

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