Last Thursday's brief meltdown: Close the gaps that encourage illicit activity - My thanks to a subscriber for this important article by Richard Ketchum for the Financial Times. Here is the opening:

US lawmakers and regulators are hard at work trying to unravel last week's precipitous 998-point stock market fall, one that many feared, at least initially, signalled the onset of another severe financial crisis.

Pinpointing the cause is crucial. And on a larger scale, the sometimes dizzying speed of change in the equity trading market, which puts a premium on innovation and competition, has made it imperative that regulators act to close gaps that effectively encourage illicit activity in the shadows.

The lag between market innovation and regulation is particularly pronounced in the increasingly fragmented area of equity trading.

There, we have seen a rapid evolution of how and where trading occurs, and how quickly and transparently it is executed.

High-frequency trading, dark pools and direct access are commonplace, compelling regulators to adapt to ensure that participants play by the rules.

A generation ago, fewer than 10 exchanges handled all US equity trades. Today, orders are routed to some 50 competing platforms.

This complex environment creates opportunities for traders seeking unfair advantage to manipulate markets.

They do so by exploiting inconsistencies or gaps created when the responsibility of regulatory oversight is divided.

Regulatory gaps and splintered oversight make it possible for trading abuses - such as market manipulation, marking the close and front-running customer orders - to be carried out furtively across many markets, with a reduced chance of detection.

My view - By chance, some of us profited from last Thursday's gyrations and we were lucky. It could have so easily gone the other way and undoubtedly did for some. At minimum, most of us saw a temporary drawdown on many long positions.

While regulation does need to take a very close look at high-frequency algorithmic trading, the reality is that regulators will always be attempting to put out fires rather than restraining arsonists before they light them. Leading participants within the high-frequency trading industry have been largely silent about the risk of collateral damage, to my knowledge, which does not reflect favourably on ethical standards.

To paraphrase Paul Volcker, the only positive financial innovation over the past 20 years has been the cash machine.

The great man also said:

"I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth - one shred of evidence."

Political Risk Rising - My thanks to Keith Rabin of KWR Advisor for this excellent article by his colleague, Scott MacDonald of Aladdin Capital. Here is a sample:

What kind of political risks do investors need to consider?

1.Euro-contagion and the rebirth of nationalism: Greece's troubles point to the limitations of the European model of peaceful economic development and extensive social net constructed on the monolith of a pan-European identity and common institutions. Part of this model focused on economic convergence - the bringing of the poorer parts of the union up to the living standards of the richer economies. This helped establish a bloc of 27 countries, stretching from the Atlantic to Russia. The current problem is that this union never established a well-defined political center and a blind eye was turned to corruption and failure to make important structural changes in a number of countries, like Greece. All of this worked as long as there was moderate economic growth, easy access to capital markets, and a willingness of some countries' taxpayers to foot the bill for those that still needed to converge. With the Great Recession of 2008-09 easy access to credit evaporated, economic conditions deteriorated, and the willingness of the wealthier countries to subsidize the poorer has given away to the view that they should pull their economic weight. The German hesitancy to provide a bailout for Greece is a clear reflection that the European model is in trouble. We would expect more fractious European behavior in the future as the sovereign debt issue is not going to disappear any time soon, with deep concerns over Portugal and Spain. Europe is shifting - it is a little less "European" and more nationalistic along the lines of individual countries. The Ultimate downside - which we do not see currently - is that the euro-zone breaks up under the pressures of fiscal retrenchment, pleas for bailouts and rising political tensions.

My view - I agree with all of this but we are probably taking about medium to longer-term political risk in Euroland, because the immediate problem has been papered over with even more debt, this time via quantitative easing. Consequently, Southern Europe can return to its laidback lifestyle with short working hours, long holidays, early retirement and caring social safety net. OK, there are likely to be some reductions in public sector pay rather than the usual entitlement rises, and the retirement date with generous pension may be pushed closer to 60. Life is tough in the first world but improving seasonal weather and the bountiful foods that it brings will soften the blow. Germans may grumble for a while longer but not without cause as they will pick up a significant chunk of the bailout tab.

The problem with our enviable entitlements in the west is that they are increasingly financed by debt rather than entrepreneurial ingenuity and hard work. There is a limit to this Rake's Progress because socialists either run out of other people's money or drive it away, and the printing of ever more fiat currency is not without its eventual consequences as history has repeatedly shown us.

No wonder the price of gold is hitting new highs in USD and appreciating against all paper currencies.

While Scott MacDonald makes a number of good points in his article, I personally do not feel that political risks are rising globally, especially when we consider some of the dire forecasts in 2H 2008 and 1H 2009. Worst case scenarios often dominate headlines during difficult times. Investors should recognise that this is usually an emotional overreaction and therefore a contrary indicator.

We have seen remarkably little of the trade wars, commodity wars and general anarchy widely forecast, although fortunately not by this service. I attribute much of the more benign outcome to globalisation, which encourages communication and cooperation. Also, the earlier embracing of capitalism by most emerging markets of consequence has enabled them to progress, increasing the likelihood of political stability in the process.

Email of the day (1) - On purchasing power parity (Ed: slightly condensed):

"Struggling here among the hustle and bustle of Bali while you relax in the tranquility of London but alas someone has to put up the good fight.

"While as you know I am a big believer and proponent of emerging markets, over the past week or two I have been shocked at how expensive on a PPP basis Singapore and Jakarta are. For awhile I was saying it was as expensive as NY - until corrected by one colleague who brought me down to earth a bit -- but in Singapore's case it is close and Jakarta is no bargain.

"To some extent I feel here like I felt in London when I attended the chart seminar and the pound was 2.07, or in summer 2008 in Mexico - wish I had shorted both currencies at that time.

"A big regret was not accepting payment for development of a site in rupiah instead of USD as if I had taken it I would have gotten 15-20% more.

"So in any case my thinking is if the turbulence continues given the relative overperformance of EM over past year, we may see relative underperformance in coming months -- and I also think that US corporations have far more fundamental competitiveness here by virtue of currency than a year ago.

"Anyway, hope all well with both of you."

My comment - All is well and thanks for the insights. Eoin is looking forward applying Behavioural Technical Analysis in this lively market environment at TCS commencing tomorrow, particularly as most of the delegates are subscribers.

Rather than a matter of PPP, I suspect the higher costs you are experiencing in Singapore and Indonesia reflect, as you allude to in your penultimate paragraph, the weakness of the USD against the SGD and IDR. Permanent deficits are a recipe for weaker currencies.

The US is currently "the safe haven by default", but this is a movable feast, as you know. I regard it as a cyclical period of outperformance within a secular trend which favours the Asia/Pacific and resources exporters which demonstrate good governance.

Email of the day (2) - On my Top-10 personal long-term equity investments:

"I'm fairly new to the site and am still navigating my way around it. Every now and then there are references to your Top 10 portfolio and the Fullermoney themes, but I'm having difficulty locating them. Could you please help?"

My comment - Welcome to Fullermoney.

For any back data, please use this site's 'Search' facility, shown in the left-hand column, fourth item down and between 'Chart Library' and 'The Chart Seminar'. Keep the search words brief because we are not Google. However if you search under 'top-10' (include hyphen and no extra spacing) you will find 66 entries. The last review of my personal top-10 equity investments by weighting was posted on 8th January 2010, so I am due for another review which I will conduct shortly.

Every word that Eoin and I have written since Fullermoney became a fully online service is still posted in the site's Archives. For our secular themes, 'Search' under 'Fullermoney themes' and also 'Fullermoney theme'.

Precious metals technical review - I will review this sector tomorrow.


Email of the day (3) - On sovereign debt ratings:

"As sovereign debt is very much in the spotlight, I wanted to forward a link to a view of ratings from an Asian publication.

"The writer makes interesting points questioning what appears to be rating agencies' West-centric stance.

"Always enjoy your and Mr. Treacy's daily commentary and the contributions of your far-flung reader base. Hope the link above adds something of interest and increasing relevance."

My comment - Thanks for the feedback and also the informative article. Sadly, the western rating agencies in question remain a joke. I attribute this to ignorance and prejudice.

The Boeckh Investment Letter: The Economy vs The Stock Market - My thanks to Tony Boeckh for his astute letter. Here is a brief sample:

Personal consumption expenditures are growing, although only at a 2% rate from last year. Retail sales are up substantially, but must be adjusted for government incentives which have been successful in causing a bulge in current spending, likely at the expense of future consumption. Worryingly, consumer confidence remains low, which is a reflection of weak income growth, high structural unemployment and excessive household debt levels. This is a grim picture particularly if income growth remains anaemic. It is important to keep in mind that the wealthiest 20% of Americans are responsible for 65% of consumption, and that their buying power is more closely correlated with stock market performance than with income. Recent stock market gains have given this source of consumption a boost, while the lower-middle class has had to be more frugal. However, asset?driven spending is a two?way street. A sharp break in the stock market and further weakness in housing prices could cause household spending to dry up again. Below, we present some charts that highlight the unbalanced and artificial nature of the recovery.

My view - This is an important point. A significant break in the US stock market would inevitably hit US consumption hard. Currently, we still have a firm US stock market. But for how long?

Currently, the S&P 500 Index (weekly & daily) remains above its rising 200-day moving average so the cyclical bull trend is still intact. However, volatility such as we have seen recently is often an indication of top formation development. Nevertheless it would be premature to conclude that US equities were in trouble on the basis of some choppy activity which is at least partially related to Europe's sovereign debt problems.

A retest, let alone break of last week's reaction low would be another matter. Meanwhile, US monetary policy remains highly accommodative. We can expect some near-term technical resistance from last month's peak centred on 1200.


Please note - Eoin is away conducting The Chart Seminar on Thursday and Friday and an additional private seminar on Monday and Tuesday. His next contribution to Comment of the Day will be on Thursday 20th May.

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