A Liquidity Correction

With the onset of High Frequency Traders, not to mention programmed trades by smart machines, the bulk of turnover can be said IS controlled by these "whatchamacallits". I can see a liquidity driven correction happening sometime soon. It kinda happened during the Greek crisis when market makers stayed on the sidelines in light of huge sell orders, thus prompting big price slides to match the sell order. That in turn triggered program based sell orders and cut loss orders, reinforcing the downward spiral. 

When you have so much of the liquidity in the hands of so few people/machines, them staying sidelined in light of a surpernormal order will trigger flash sells which can cause stomach churning down swings even though in all likelihood, these downswing will not lasts more than a day or two once the real cause has been determined. So beware of upcoming flash crashes
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John Maudlin's blog:

Before the credit crisis, market makers like Bear Stearns, Goldman Sachs, Merrill Lynch, Morgan Stanley, and Bank of America created a huge amount of the overall liquidity in major markets by consistently taking “the other side” of trades. If the markets were selling, market makers bought, and vice versa.

In the wake of 2008, the big market makers either went out of business, merged, and/or were forced to operate at much lower levels of leverage. The net effect is far less trading volume from market makers and other forms of “real money,” to the point that high-frequency trading and ETFs accounted for about 66% of all trading volume in 2010. While that number has fallen to about 50% today, equity mutual fund flows suggest that higher trading volume from smaller investors, not the resurrection of market makers, is responsible for the shift.

In fact, the following chart from Credit Suisse suggests that the average daily trading volume from “real money” fell by more than half from 2008 to 2012, as high-frequency trading advanced. I do suspect that “real money” volume is rising today with the rotation that is underway into an overvalued, overbought, and overbullish market (but let’s save that for our conclusion).

Understanding how the structure of market participants has changed, let's think about the effect of there being less market-making volume to balance against high-frequency trading and the retail/institutional herd.

On May 6, 2010, the markets sold off for most of the day, and market makers expanded their volume as the media ran all-day coverage of a small riot in Greece. But (and this is critical), market makers who can no longer buy at 40x leverage will carry only so much inventory overnight. At some point market makers must stop buying ... and they did when a large sell order came into the market toward the end of the day on May 6. The market makers stepped back instead of providing liquidity, precipitating a sharp drop in prices. Then many of the HFTs shut their systems down, seeing an irregular trading pattern and fearing another “Quant Crisis” like the one in October 2007. Liquidity dried up in a matter of minutes, and the market went into free fall … triggering stop losses and emotional selling from the general public. (As they saw the market collapse and the rioting in Greece, people may have thought, “Something big just happened and I am late... sell everything!”). Without market makers to provide volume, an orderly sell-off became a chaotic collapse.

Now, with market-maker volume way down, a similar situation could develop again; and once again the general public will rush to sell if liquidity evaporates. We should really think about this dynamic, because the next correction may look more like the stock market crashes of 1929 or 1987 as opposed to the more gradual "cascading crash" we all experienced in 2008.

With that in mind, investors will do well to pay attention to the ever-changing structural makeup of the markets before blindly jumping in. Just because US stock markets – along with a lot of the major markets around the world – have found new highs since 2008 doesn’t mean they have healed structurally. It doesn’t mean they are stable. And with long-term valuations at historic levels, both on an absolute basis and relative to the rest of the world, US equity markets are both unstable AND overpriced.

The inevitable correction that is coming to US markets could be a catalyst for a downturn in the broader economy, and without much of a warning. It could be another lion, prowling through fiber-optic cables, data feeds, and stock exchange servers.

I continue to believe that high-frequency trading should be reined in. It is creating the illusion of liquidity, which can dry up in a heartbeat while at the same time sucking billions of dollars from the trading of individuals and institutions.