WHAT IS HAPPENING WITH WALL STREET?

By Roland Watson
December 8, 2018
http://www.dictatorwatch.org/articles/wallstreet.html

United States stock markets are experiencing wild gyrations, which spread quickly to other markets around the world, and all the while the U.S. economy is steady and doing well. What is going on?

While there are countless factors involved, four have been critical, month after month. Three involve Trump, and the last the markets themselves.

1. The Federal Reserve Bank

Janet Yellen as Fed Chairperson guided the U.S. economy through the extreme challenges of the Great Recession. She did a superb job, among other things keeping interest rates very low to ensure that the economic recovery did not fail. But, she had been appointed by Barack Obama, so Trump fired her. Were it not for his hatred of all things Obama, he probably would have kept her. Fed Chairpersons often serve terms that extend over multiple presidencies.

Trump chose Jerome Powell, a former Wall Street investment banker, to replace her, and many people breathed a sigh of relief, since he too seemed to be a moderate on interest rates. But in the last year he has embarked on a series of many would argue unnecessary rate increases, and telegraphed that this will continue through 2019.

The Fed is steward of the economy, and in practical terms this means it attempts to balance employment and inflation. Its policy goal is to reduce unemployment until prices start to rise, at which point it raises rates to hinder the increases. U.S. unemployment under Obama had fallen dramatically, but without any increase in inflation. But then, following the policy of interest rate hawks, Powell started to raise rates.

Wall Street is now worried that he will raise rates so far that he sabotages the economy and drives it into a recession. Many important economic indicators such as home sales are already starting to decline. Unfortunately, interest rate hawks are only satisfied that inflation won't increase when it literally can't, when people are being laid off and the economy is shrinking.

This is the biggest factor is the present market tumult. If Powell keeps raising rates investment analysts are convinced the U.S. expansion will end. He will force the economy into recession at which point company profits, the fundamental basis for stock prices, will fall.

Professional stock traders are simply trying to get ahead of the curve.

2. The trade war with China

As an avowed enemy of China's communist dictatorship, who for years has called for a boycott of Made in China goods, and who has also written a basic guide to the democratic system which has been translated into Chinese by a leading dissident and been read by at a minimum hundreds of thousands of Chinese people, I of course want the United States to have a firm pro-democracy China policy. The CCP sorely represses the people of the country, and in trade terms it has refused to open its markets to imports all the while demanding transfer of high technology secrets by Western companies that want to produce their goods there. We do need to support the democratic aspirations of the Chinese people, and we have to stop this trade abuse.

Trump though, and if you excuse the joke, has been a bull in a China shop. He is breaking everything. He doesn't understand how the Chinese communists negotiate, and even if some of his advisors do, he doesn't follow their policy and he furthermore changes his mind publicly and stridently on a regular basis. Negotiation with China should be extremely strong. It is the only thing the communists respect - strength. (Mao said power comes from the barrel of a gun.) But this should for the most part be behind the scenes, with only infrequent public statements. This type of negotiation however leaves no room for Trump's addiction to bombast, hence his outbursts.

Last week's market spasm derived from the news about his meeting with Xi Jinping in Argentina - that he would hold off raising tariffs for three months, followed the very next day by a renewed threat to do just that.

Overall, the market has capitulated. The thing it hates more than anything is uncertainty and with Trump there is never certainty. For one day traders thought they would have at least a month or so of peace on the China front, and then Trump went crazy again.

3. The outcome of the Mueller investigation

The final Trump factor is of course Special Counsel Robert Mueller. Traders have been anticipating for months the results of his investigation, that he will present if not indictments a strong case that the Trump Campaign conspired with Russia. They have priced into their models everything up to and including impeachment, and even Trump fighting impeachment by openly calling for the U.S. Armed Forces to back him personally, i.e., by attempting a coup.

This isn't to say that the markets won't fall when Mueller announces his findings. An additional decline of at least ten percent is likely. However, the fall should be short-lived. At this point traders hate Trump so much that they would welcome a more traditional Pence Republican presidency (assuming that is how it plays out).

In summary, Wall Street is afraid that Jerome Powell's interest-rate policy will cause a recession; that it will be exacerbated by Trump's incompetent handling of trade issues with China; and that the Mueller hammer is about to come down. There is, however, another factor as well - the nature of current stock market participants.

4. Hedge funds and high-frequency traders

Lots of people invest in the stock market. This includes individuals directly, who buy and sell the shares of specific companies; to mutual funds, and which group the investments of individuals, including high-wealth individuals, and institutions, such as company and government pension plans. These mutual funds in turn follow two basic approaches, (1) trying to match the market - indexing; or (2) trying to beat it, such as with Warren Buffet's value-investing strategy, where through careful analysis you try to uncover good investments that other people have missed.

This is all pretty mundane though, and not without risk. For indexing, if the economy goes down so will your stocks. And for value investing, it is hard to find something that other people haven't also seen. Indeed, there is persuasive theory - the efficient markets hypothesis - that over time beating the market is impossible.

What happens therefore is that people try to game the system. There are many ways in which they maneuver to get access to "inside information," and only a few of which are in fact illegal. (Wall Street has a major lobbying effort dedicated to preserving many different types of inside advantages.) For the funds, they may even try to manipulate the market directly, to cause it to move in a particular way and from which they have already positioned themselves to profit.

In the 1980s (when everything bad in a modern context first developed on Wall Street), a new type of investment fund was created, and which is now the day-to-day driver of market volatility. These are called hedge funds. They frequently if not always use borrowed money, not only what their investors have pledged, and they engage in a wide range of risky strategies (beyond that of using borrowed funds). Hedge fund managers are for the most part only paid when they beat the market, the different indices, but if they do the sky is the limit. Many people have made hundreds of millions of dollars, if not a billion or more, in a single year. Because of this, they have a huge incentive to risk everything, and also to cross the legal versus illegal line - when they think they can get away with it.

An estimated 70% to 80% of daily market trading is now made by hedge funds, specifically the classes of hedge funds that use quantitative high frequency trading models. (The total daily volume for the New York Stock Exchange and NASDAQ can approach 10 billion shares a day, and this excludes all the commodities, options, futures and other instruments that are also bought and sold.) These traders have an absolutely dominant impact. Their models, which are designed by mathematicians and statisticians, track a massive and ever-changing set of factors - economic, market, and company-specific, looking for patterns. They are programmed to trade automatically when specific relationships between the different factors surface.

In some cases these patterns reflect market inconsistencies where something is available for one price in one location and another price somewhere else. They simply recognize and take advantage of the discrepancy. (This is called "arbitrage.") At the other end of the scale, though, the illegal end (or which if not in a specific case should be illegal), they attempt to manipulate the patterns, such as through price-moving announcements by political and media allies, and which announcements they already know about if they didn't even help orchestrate them.

What has been happening in the big market falls this year also reflects one final aspect of investing. From yet another perspective there are two other approaches - fundamental trading versus technical. Fundamental is just that - trying to figure out how much something is really worth, and if the price is lower then buying it, or selling it if it seems to high. Technical trading is completely different. It is based on "momentum," the psychology of market participants at a particular moment in time. At its core it represents a simple idea. If something goes up a lot, it probably needs a breather; likewise if it goes down. A technical level is a measure of where people think psychology might change, and the price will go either up or down. (It "bounces" off the level.) These levels in turn are derived from "charts": histories of price movements for an investment in the preceding weeks, months and years.

Summary

This is how the recent stock market crashes have come together. High frequency funds - the "quants" - dominate the markets. Their models track technical levels. When these levels are broached, the systems activate trades. In the above described political context, if the analysts think a recession is more likely (no matter what the economy is doing right now), because of Fed interest rate increases, or a trade war with China, or the Mueller investigation, or just because of the massive uncertainty generated by the United States having a deranged president, they sell. Then, when they do, stock prices fall, perhaps through the next technical level. If that happens, more computer code from their trading algorithm kicks in, and they try to sell even more. It is a classic negative feedback cycle.

Of course, someone also has to buy. Stock transactions are matched trades. Someone agrees to sell and someone else agrees to buy, at an exact price. Most funds at some point stop selling. Their circuit breakers are triggered. What might happen though is that a few people still literally have to sell. The usual reason is that they have bought investments using loans and now they have to sell to make sure they have enough money to pay them back. But these are desperate sellers. And the people who remain willing to buy know it. So, they say they will only buy if the price is lower, often a lot lower, but because of their situation the sellers have to agree. Stock markets regularly fall dramatically in the last half hour of trading for precisely this reason. There may in fact be only small volume, but the final trade, the one at the most desperate price, sets the level for the day.

The purpose of stock markets is twofold. They provide companies a way to raise money - by selling shares, and they provide a means for savers - investors - to participate in the broader economy. The current market setup has diverged wildly from this purpose. The quants and similar types of hedge funds should either be banned, or regulated and taxed in a way such that they are effectively controlled. They do not, as they often argue, add "liquidity." Instead, they distort market behavior with the result that company plans are undermined, the overall economy is damaged, and individuals investors lose their savings. Different types of hedge funds, ones that traded in "derivatives," caused the 2008 financial crisis and the Great Recession. Trump together with the new hedge funds could easily cause in 2019 another recession or even potentially an economic depression.

Why wasn't anything done after 2008 to prevent this from happening again and why isn't anything being done now? The answer is two-fold. The hedge funds and their billionaire owners make huge donations to political candidates, both Republican and Democrat. The election winners then protect their donors. Second is the issue of revolving doors. The officials, when they leave office, want to get high-level jobs at the hedge funds. That way they can cash in and get extremely wealthy too. In summary, the American political system at its core is completely corrupt, and the only people who don't suffer for it are the traders on Wall Street and the officials in the government.

Final Note: Presuming that new regulation could be imposed, and that markets could go back to their original purpose, there is still the question: Is this enough? The incentives of capitalism which follow from its primary directive to make profit always lead to government corruption, exploitation of workers, and the destruction of nature. This is as inevitable as gravity. Capitalism has had its chance, but just like communism it simply doesn't work. It does not satisfy the needs of all people and all species. We therefore must be inventive and design something new. My view, as I have written again and again, is that we should confiscate the bulk of the assets of the wealthiest people (through extremely high estate and income taxes), and then pay down the deficit, help the poor, and restore natural habitats, and further that all for-profit enterprises should be restructured as non-profits. The people employed at places like the Red Cross and Amnesty International work just as hard as the people at Goldman Sachs and Facebook. It is a fallacy that we need the promise of obscene wealth to be creative and to perform. Literally any type of enterprise that seeks to accomplish any type of objective can be set up as a non-profit. I'm not saying that it wouldn't be a complicated social transition, but it can be done. The choice isn't between intensely concentrated and extraordinarily unfair ownership by the private sector (capitalism), versus ownership by the government (communism). Rather, the solution is the widespread propagation of this new type of egalitarian need-fulfilling social organization.

This would also mean the end of financial markets, at least as they exist now.