Bear Mountain Bull

Lots to digest in John Mauldin’s letter this week. He’s worried about Japan — and the rest of the world too, with good reason.

And he’s got a few comments on the topic-du-jour, which is high frequency trading:

There is a lot to cover in what will be a very interesting letter. I suggest removing sharp objects or pouring yourself a nice adult beverage.

But first, I want to direct the attention of those in the US finance industry to a white paper written by Themis Trading, called “Toxic Equity Trading Order Flow on Wall Street.” Basically, they outline why volume and volatility have jumped so much since 2007; and it’s not due to the credit crisis. They estimate that 70% of the volume in today’s markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn’t get to play. This is a game only for big boys who can afford to pay for the “arms” needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn’t affect you? That “tax” is paid by mutual funds, your pension fund, and every large institution.

Frankly, this is outrageous. The more I read the madder I got. And it is going to get worse as computers get faster and software more intelligent. We need rules to level the playing field. Themis suggests one simple one: just make it a rule that all bids have to be good for at least one second. That would cure a lot of problems. One lousy second! In a world of microseconds, that is an eternity.

Goldman Sachs went after an employee who stole some of their latest and greatest software this last week. The US assistant attorney general said in the courtroom that the software had the potential to manipulate the market. Imagine that. I am shocked. There is gambling going on in the back room? Gee, commissioner, I had no idea.

All this “algo” (algorithmic) trading also gives a very false impression of volume. If you are a fund and see 10 million shares a day traded, you might feel comfortable that you could hold one million shares and exit your trade easily. But if 80% of the volume is false “algo” trading, that volume isn’t really there. You may have a position that will be a problem if you want to exit, and not know it.

“High-frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.” (Themis Trading)

We are literally talking billions of dollars here. The SEC needs to step in and stop this, and soon. This is a lot more important than the salaries of investment professionals, for which the Obama administration today suggested new rules, which would allow the SEC to oversee salaries at member firms. Seriously? They don’t have enough to do already?

The link to the white paper is http://www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf. Themis Trading is at http://www.themistrading.com/.

On Japan and the US:

But I think the central bank is going to figure it out. If they do not monetize the debt, rates will have to rise over time (say the next 2-3 years), and that is most definitely a problem. Monetizing the debt would mean the yen would fall in value, which is something they actually want to happen. How much monetization? When? I don’t know, and I doubt they do. If I were the head of the central bank or the government, I would not sleep easy.

Japan is the second largest economy in the world. There is a rule in economics: “If something can’t continue, then it won’t.” Japan can’t continue down this path. All the trends are going against them. Sadly, Japan is going to hit the wall, maybe some time in the next few years. This will be very bad for the world, as they have financed much of Asian growth. They do in fact buy a lot of world goods, and their buying power is going to fall. This is going to mean fewer US and European jobs. Not to mention fewer jobs in the countries that are Japan’s neighbors.

And unless we change things in the US, this will be us in less than ten years. As in hit the wall, serious depression, etc. I am hopeful that we can actually get our act together. But then I am an eternal optimist.

Buddy, Can You Spare $5 Trillion?

I have been writing for months that I don’t think the US can find $2 trillion dollars this year and then come back to the well for another $1.5 trillion next year without serious disruption in the markets. Where do you find that much money when all the rest of the world also wants to borrow massive amounts? How much are we talking about? The friendly folks at Hayman actually spent the time to add it all up. This is not a comforting graph.

The graph shows the US will need to issue $3 trillion in debt. “Wait,” I asked, “I thought it was only 1.85″ The answer is that the number has grown to almost $2 trillion (as I wrote it would). Then you need to add in off-budget items like TARP, state and municipal debt, etc. Pretty soon it adds up to another trillion. All told, Hayman estimates that the world will need to find $5.3 trillion in NEW government financing. Never mind the needs of corporations or individuals or commercial mortgages, etc.

I am still trying to get my head around this. Let’s hopefully assume that they made a mistake and it is “only” $4 trillion. Where do you find that kind of money in a global deleveraging recession?

The World Bank says that total world GDP in 2008 was $60 trillion (http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf).

That means we need to find almost 9% of world GDP to fund the new government debt. Gentle reader, this is a serious problem. And now the next chart. Remove sharp objects or take another drink.

This one is titled “The Potential Shortage of Capital to Fund Treasuries.” They take into account the need for corporate borrowing, new corporate equity issuance, real estate debt, capital inflows and outflows, household savings, etc.

Bottom line? There is simply not enough available capital under current conditions to do it all. Something has to give. More household savings? More foreign investment (flight to safety, as the rest of the world looks even worse)? Reduced corporate borrowing and thus less GDP growth? Higher rates to attract more foreign and US investment?

The combinations are infinite, but none of them bode well. Increased household savings means less consumer spending. To attract more foreign investment (in the amounts that will be needed) will mean higher rates. And this is 2009. What happens in 2010? And 2011?

Go read the whole thing, and check out the charts.