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Rigor Mortis Of The Robo-Machines

Submitted by David Stockman via Contra Corner blog,

Call it the rigor mortis of the robo-machines. About 430 days ago the S&P 500 crossed the 1973 mark for the first time - the same point where it settled today.

In between there has been endless reflexive thrashing in the trading range highlighted below. As is evident, the stock averages have not “climbed” the proverbial wall of worry; they have jerked and twitched to a series of short-lived new highs, which have now been abandoned.

Surely most thinking investors have left the casino by now. So what remains is chart driven trading programs, racing madly up, then down, then back up again - rinsing and repeating with ever more furious intensity.

^SPX data by YCharts

Accordingly, it goes without saying that the central bank driven casinos which now pass for financial markets are no place for savers, investors, rational speculators or any other known type of carbon unit. More than 80 months of ZIRP and nearly two decades of central bank financial repression have destroyed free market price discovery and eviscerated all of the normal mechanisms of stability and discipline that govern functioning markets.

Long ago short sellers were destroyed by the Greenspan/Bernanke/Yellen “put” and the endless cycle of buy-on-the-dip upswings that took the market averages to ever more lunatic levels. At the same time, speculators came to realize that their free money carry trades were not at risk because the Keynesian statists who have usurped control of the central banks promised to give them months and months of warning before tampering with their guaranteed cost of carry by even so much as 25 basis points.

Needless to say, this kind of “forward guidance” is endlessly praised by the talking heads of bubble vision as some kind of enlightened form of central bank honesty and transparency. No surprises and all that.

Please! Transparency in manipulating and pegging the price of money is not constructive monetary statesmanship; it is a front runner’s dream and as anti-market as it gets.

For crying out loud, if you tell speculators that their overnight carry cost is pinned to the second decimal place for months into the future, they will bid anything in sight that has a yield or appreciation potential, fund it in the money market directly or indirectly, and roll the carry night after night.

At length, the upward momentum becomes so regular that the machines take over. What you have at that point is not a stock market; it is a chart plot fashioned by algos.

One of the most pernicious forms of this machine takeover is the ETF plague. Even the most inveterate human speculator of this generation, Carl Icahn, got that right when he properly denounced ETFs as a disaster waiting to happen. His CNBC interviewer almost lost his lunch when Icahn said so.

The truth is, ETF’s are not a natural product on the free market—notwithstanding all of the phony drumbeating about capitalist efficiency and innovation spewed out by their sponsors. If there were a natural investment propensity to invest in industries and sectors, as opposed to specific companies with discoverable profit prospects and appropriate discount rates, they would have been invented long before the mid-1990s when ETFs first appeared.

And it didn’t take high speed computers to make them possible. The pyramid schemes in the utility and other sectors during the late 1920s amounted to ETFs in the ink and ledger age.

What ETFs do provide is just one more avenue for the machines to arb fleeting inefficiencies in price alignments between the stocks in the underlying basket and the ETF, and to trade still more chart patterns in the secondary market.  They accomplish nothing for true liquidity or market depth; they only provide an opportunity for market makers to clip bps, sponsors to collect fees and traders to churn for nickels and dimes.

Certainly there is no reason to believe that ETFs ever facilitated the raising of primary capital, which is the actual function of the secondary market. After all, prior to the mid-1990s ETFs didn’t even exist, yet massive amounts of capital were raised by equity issuers in IPOs and secondary offerings accommodated by well functioning secondary markets.

Even as late as the dotcom bust in April 2000, there were only $100 billion of ETFs outstanding. Since then thousands of these gambling devices have been created by Wall Street dealers and their giant clients which dominate the so-called asset management business.

Fast forward to the third bubble peak this century, however, and there is more than $2 trillion of ETFs outstanding, representing a 20X gain in hardly 15 years. As was demonstrated during the ETF meltdown last Monday morning, they surely qualify for Warren Buffett’s famous description of derivatives as financial weapons of mass destruction.

Exhibit number one is the chart below for IBB, the ETF which tracks the NASDAQ Biotechnology index. It is a pure product of the robo-machines. Between July 2013 and its peak of nearly $400 per share last month, the index gained 130% or nearly $600 billion of market cap.

As is evident, the machines faithfully traded the 50-Day SMA and smartly bounced off the 200-Day SMA on the occasions when the IBB modestly sold off. But what the chart does not reflect is anything having to do with honest price discovery or real value. That is evident in the absurd valuations reflected in the recent July peak valuation at $400 per share.

Yes, there are plenty of interesting breakthroughs happening in the biotech world these days, but that has been true for more than a decade. It does not begin to explain how the biotech index soared by 6X since the March 2009  bottom and by nearly 300% just in the last 48 months.

Here’s actually why. At its peak a few weeks ago, the NASDAQ biotech index of 150 companies was valued at nearly $1.1 trillion. Yet the LTM net income of the entire group was only $21 billion, meaning that the index was trading at 50X profits.

And that wasn’t the half of it. Among these 150 biotechs there were just 25 companies that had any profits at all. This latter group included  big cap giants like Gilead, Amgen, Shire, Biogen, Celgene and 20 others, which among them had $30.5 billion of net income and accounted for $780 billion of the total index market cap. At the implied PE multiple of 26X, even these profitable companies were valued at pretty sporty levels.

But there’s no denying the bubble mania when it comes to the remaining 125 companies in the index. These companies were valued at $280 billion, but posted aggregate losses of nearly $10 billion in the most recent LTM reporting period.

So, yes, there is a stupendous bubble in biotech. In this instance, it amounts to well more than one-quarter trillion dollars of bottled air.

These preposterous valuations, of course, were a direct result of six years of free ZIRP money to the carry trade gamblers and Wall Street’s self-evident confidence that the Fed is petrified of a hissy fit and will not hesitate to keep the juice flowing indefinitely. But the fact that 125 companies classified as “biotech” and included in the IBB basket were valued at $280 billion despite a massive accumulation of losses over many years underscores the special role of ETFs in helping to inflate the Fed’s latest and greatest bubble.

Absent the blind bid for the IBB basket most of these start-up companies could never have achieved their current lofty valuations, given their totally uncertain and unpredictable prospects and their ragged and, in many cases, non-existent financial histories. That is, dozens of the companies in the IBB do not even have revenues; they are start-up “burn babies” that appear to be viable business enterprises only by dint of consuming venture funding and IPO capital to fund their payrolls and operations.

Nor does it wash to say “let a thousand start-ups bloom”. When equity market valuations are massively falsified, as is the case with much of the IBB basket, the result is a pointless destruction of scarce economic capital.

Indeed, biotech start-ups that have been flipped from one round to the next of venture capital funding; and which then are ultimately sold into the public market as an IPO and finally into the IBB basket bid—–each time at higher and higher valuations—- are little more than parasites riding on a conveyor belt of economic waste that enriches speculators along the way.

Until it doesn’t—–that is, when the bubble music finally stops.

That’s where the IBB stands today. During the market fracture of recent weeks the IBB has plunged by 15% and has decisively broken the 200-day SMA that has provided support for the robo-trader buying spurts in the past.

Moreover, the 50-Day SMA has already rolled over. So it is only a matter of time before the machines change gears and begin to sell the rips rather than buy the dips.

IBB data by YCharts

The fact is, the stock market casino is booby-trapped with thousands of these Wall Street IEDs (inherently explosive devices), and many of them are strapped to even more incendiary arrangements. That is, they are double and triple leveraged to the underlying basket.

Here’s the thing. There is today only about $8 trillion of equity mutual funds, and when you subtract from that the explicit index funds and the closet indexers, what you have is a universe of active equity managers that is not much larger than the $2 trillion of machine driven ETFs now outstanding.

Worse still, the remaining active managers have increasingly resorted to ETFs to allegedly “hedge” their portfolios or to gain and edge against their benchmarks. During the long bull market that particular form of cheating has been well-rewarded because each time the machines bought ETFs on the market dips, active manager returns went along for the ride. And when in the last year, the rigor mortis of the robo-traders set in, active managers took credit for the rips.

Needless to say, the whole house of cards is now teetering on trading algorithms and chart points. As those pre-programed “sell” triggers are hit the ETFs will go into reverse gear, selling the descending chart points rather than buying the ascending ones.

Indeed, the so-called “market makers” who create and sell new ETF shares in response to a rising market will now be furiously discounting their bids and liquidating their underlying baskets of stock in response to a wave of redemption offers. So-called active managers will then get caught up in the selling crescendo, adding the human emotion of “panic” to the cold calculation of the machines.

At Jackson Hole last week Stanley Fischer told CNBC that he saw no sign that zero interest rates have done any damage to financial markets or engendered any risk of instability.

Well, pray tell, what planet does this man live on? The ETF driven meltdown in the casino creeps closer to the surface with each successive market swoon.

Yet when it blows, Fischer, Yellen and the rest of their posse will profess total surprise, and start blathering about the outbreak of some kind of invisible financial ether called “contagion”.

No it isn’t “contagion”. The whole complex of booby-traps now embedded in the financial markets——trillions of ETFs, record junk bond and CMO issuance, rampant gambling in the OTC “structured products” market——is the handiwork of central bank destruction of the money market.

For proof of the latter proposition just scroll back about 108 years to the Panic of 1907. Back then there existed the closest thing to a free market that has every existed in the financial system. It was the massive broker call money market, and it functioned without intrusion of a central bank or a price fixing monetary politburo or an agency of the state committed to the specious doctrine that wealth can be created by arbitrarily inflating the price of financial assets.

On some days during that short-lived two or three month “panic” the call money rate surged by hundreds of basis points and reached a level of 90% at its peak. At length, the speculators of the day—–copper barons, trust bank promoters, highly leveraged real estate developers and call money financed stock punters—– were carried out on their shields.

In due course, greed and gambling got purged, the stock market found a new, sustainable footing, and the US economy entered a renewed period of robust growth until the eve of World War I.

Yes, there was no Fed then. Instead, there was an honest free market in money that enabled the capital markets to do their essential job of raising capital, pricing securities honestly and placing investments with long-term savers.

By contrast, today we have a money market run by 19 people who have endlessly displayed that they are clueless about what is happening in the very casino that they have confected.

No wonder main street is again threated with a meltdown—this time owing to the plague of ETFs and all the other ZIRP-enabled booby traps and IEDs.

And no wonder the talking heads of bubble vision think a bottom is being put in when, in fact, what is playing out on the stock charts is the rigor mortis of the robo-machines.