Those Lights Are Off On Purpose
Forget for a moment all of the chitchat about how it was a computer error, and not a human error, that triggered Thursday’s stumble. Perhaps that is true – we may not know for a while – but it isn’t relevant. People who live parasitically on the market, like the talking heads on CNBC, want to get you to focus on the 1000-point slide yesterday and persuade you to think “oh, I guess it was all a mistake! I don’t want to miss the rally back up! Buy! Buy!”
But that is a red herring. It wasn’t a computer glitch that caused the oil spill in the Gulf, the riots in Greece, the hung Parliament in the UK, or the tightening of credit conditions between banks. It wasn’t a computer glitch that produced the first 350 points of yesterday’s slide (the part that stuck around until the close) or the 250-point decline today that was eventually trimmed to “only” 140 points. And it wasn’t a entirely a computer glitch that produced the two heaviest trading days in equities, with the exception of a couple of triple-witchings, since…are you ready?…October 2008. It wasn’t a computer glitch that lifted the VIX higher today: the VIX closed Friday around 41, about double where it was on Monday’s close and the highest level since April of last year before the Great Bounce of 2009 was very much underway.
It is frankly a little disconcerting that the market wasn’t able to do better today, given what news there was. Rumors circulated for much of the day about a supposed €600bln backstop that the ECB might be putting in place (for banks, maybe?) over the weekend. Germany’s parliament approved their part of the Greece bailout – which was somewhat surprising, and was probably encouraged by the waterfall decline in equities. And, of course, the Employment data.
Payrolls soared 290k, with a 121k upward revision to prior releases. Moreover, the gain wasn’t merely in Census workers: government hiring was only +59k. The net 411k jobs in the month, about 350k on private payrolls, is an economy-lifting-off sort of number. Except…somehow, this robust labor market was not picked up by ADP. And it wasn’t hinted at by Initial Claims, which generally fall as a prelude to Payrolls gains since employers typically stop firing people before they start hiring people. And the man on the street doesn’t see the labor market getting much better, based on his response to the Consumer Confidence survey “Jobs Hard To Get” question. Those are the top three indicators of employment after the employment data itself. The Payrolls number is an outlier.
That doesn’t mean that the data is wrong, but I think there’s something else going on here and I was pretty near to anticipating it yesterday. Unemployment also rose in the report, by 255k, and the Unemployment Rate rose to just under 9.9%. That is, more people this month found themselves employed, and more people found themselves unemployed.
As I suggested yesterday, the approaching end of the Emergency Unemployment Compensation program seems to have encouraged some people to start looking for work, discouraged or not. Many of them did not find work, and this is why I anticipated some chance of a rise in Unemployment. What I missed is that some of them found work, too.
I guess it’s natural to treat the number of new jobs as given, especially when the number of people looking for those jobs is clearly greater than the number of openings. But that’s not quite the right way to look at it. There are clearly some jobs that are open, and that remain open for a while, because despite the size of the industrial reserve army of the unemployed, the candidates are not a match (geographically, temperamentally, skill-wise, compensation-wise) for the jobs that are available. For example, despite the 9.9% unemployment, there are at least three or four sell-side firms and several buy-side firms as well that are looking for TIPS traders. That’s called structural unemployment. There are simply no experienced TIPS traders available among the millions of unemployed.
But when some of those folks come off the couch and dust off the resumes, some of them happen to match those jobs. More people looking for jobs actually produces more matches. Think about it like one of those games where you swirl a marble around and try to get it to settle in a little divot that has been made in a surface. If you add more marbles, then you increase the chances of getting a marble to stick – simple as that. It hadn’t occurred to me before, but I think that’s what is happening with Payrolls. Of course, either way it is good news for the economy, because it means more people are employed than would be otherwise, but it isn’t necessarily a sign of a rise in job growth as much as it might be a sign of a (one-time) decline in structural unemployment. We need to see some confirmation from other indicators before getting too excited that a normal recovery is, against all odds, underway.
One of the basic threats to the market these days, which I didn’t mention above, is the financial bill wending its way through Congress. The bill attempts to shackle all sorts of risk-taking, and to separate (where it cannot easily shackle) cheap capital from risk-taking activities. As I have noted before, the reason that market-makers are able to make markets – an inherently risky task – is that they tend to be associated with strong balance sheets with a low cost of capital. If you sever that bond, you reduce the market-maker’s ability to provide liquidity. And when you do that, you start to see ugly gaps like the one we saw on Thursday, more often. Why did some stocks trade to zero? Was it because of market manipulation, as Maria Bartriromo shrilly and irresponsibly suggested? Of course not. It was because market makers turned off their machines as the market slid, and some market orders were placed when the existing bids had been cleaned out. Market-makers serve a time-disintermediation function, matching the sellers of right now with the buyers of thirty seconds from now; when they are gone then the market order of right now just hits whatever bid happens to be there now. I suspect the “software glitch” that is being investigated is simply that the software failed to check and make sure there was a bid before hitting it.
About a month ago, in a response to a reader’s comment, I predicted that if the Volcker Rule passes, we would have a 40% decline in stocks within 5 years (see the comment at the end of the article here). I didn’t expect that 10% of that might come in a single day, but we almost got there and the Volcker Rule isn’t even law yet. Some traders in 2008 tried to make markets as best as they could, except for a brief period at the peak of the crisis when bank risk desks told everyone to basically stop trading. Those traders figured that if they did well, they’d be reasonably compensated for it. Now, traders know that they won’t get compensated for it, and probably will be vilified if they do. “This kind of risk isn’t in my job description,” they’re going to say more often. Take away the capital they can lean on to make prices, so that if they’re wrong they risk the firm itself, and it will get even worse.
We really need to take deep breaths before doing to financial services what we did to health care: we passed through brute force an ill-considered and overreaching bill whose unintended consequences are likely to be far larger than the authors of the bill can imagine. Let’s pass the rules incrementally. Discuss them. See what happens when you pass some of them. Read thoughtfully analyses such as this one (really worth reading) from law firm Cadwalader, Wickersham & Taft, discussing some of the big problems with the derivatives legislation.
On Monday, we will turn on the Bloombergs to see what happened in Europe over the weekend. That is all we can do, as there is no economic data on the calendar. There are a couple of TBill auctions, and while I normally pay less than zero attention to those auctions I will keep one eye on these as a fear gauge. I will also watch LIBOR (see Chart below, source Bloomberg), which is showing some strains in the interbank markets. Money is still changing hands – the deepest part of the crisis in 2008 occurred when 3-month money wasn’t available at any price – but stresses are showing. Let’s cross our fingers and hope that all we get out of this is a stock market that is closer to fair value. Good luck to you.