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High Frequency Trading (HFT) - another imaginary hobgoblin

To paraphrase H.L.Mencken, HFT is another in the endless series of imaginary hobgoblins designed to keep the populace alarmed and hence clamorous to be kept safe by government intervention. In addition, it seems that HFT is being set up to be a scapegoat -- something to draw attention away from the roles played by central banks and governments -- during the next financial-market crisis.

HF Traders use powerful computers running sophisticated algorithms that analyse all existing buy/sell orders and then enter and exit trades within seconds, or even within fractions of seconds, with the aim of capturing a tiny (perhaps just a fraction of a cent) profit on each trade. They rarely hold positions for more than a few seconds and never hold positions overnight. Consequently, while they can substantially increase the daily trading volume on an exchange (it is estimated that about 50% of trading volume on the NYSE stems from HF trading), they will not affect anyone who is not, himself, attempting to scalp a cent here or there by rapidly moving in and out of positions.

As an aside, the fact that about 50% of NYSE trading is now HFT-related means that high-frequency trading firms will often be on both sides of a trade. As a result, the fraction of a cent profit made by one HF trader will often be associated with an equivalent loss by another HF trader.

The upshot is that long-term investors and the majority of other market participants need not concern themselves with HFT, except to the extent that it is used to justify more government involvement in the markets. This (the potential for it to be used as an excuse for more regulation) is the real danger posed by HFT.

According to the scaremongers, HFT justifies more government 'regulation' of markets because it gives some traders an unfair advantage. HFT may well give some day-traders an advantage over other day-traders, but so what? The first users of a new technology often gain an advantage over their competitors. This should be the way of the market world and is not unfair in the proper meaning of the word. An alternative would be to create a draconian regulatory structure that prevented anyone from operating more efficiently than the slowest, dumbest participant.

A point that needs to be understood is that nobody, as a result of HFT, is forced to buy at a higher price or sell at a lower price than the price at which they want to trade. If you place a limit order and your order gets executed then the price you pay or receive will be your limit price regardless of how much high-frequency trading is going on at the time. Of course, if you place market orders instead of limit orders then you are deliberately putting yourself in a position where you can be taken advantage of by other traders. Not just high-frequency traders, other traders in general.

Another point worth noting is that high-frequency trading is not, as some commentators have claimed or implied, an effective license to print money. Some HF traders have made a lot of money, but others have gone broke due to the high costs of operating in the space. Some of the early-movers in the HF trading space had years when they never had a single losing day, but this competitive advantage was not sustained and in some cases the relentless winners became losers. Furthermore, if HF trading continues to remain popular or gain in popularity then the already-miniscule per-trade profit margins will shrink as the traders cannibalise each other, causing the overall business to either die a natural death or, more likely, become a niche that generates satisfactory returns for only a small number of firms.

Of far greater importance, the actions over the past few years of the Fed and other central banks -- organisations that certainly do have a license to print money -- all but guarantee that another major financial-market calamity will happen within the next two years. When it does, look for a finger of blame to be pointed at HFT. Anything to prevent the masses from identifying the true culprit.

Uranium Update

The uranium-mining sector, as represented on the following daily chart by URA, began to strengthen last October and clearly broke out to the upside from a well-defined channel in February of this year. Although the channel break provided obvious confirmation of a trend reversal, it led to URA becoming 'overbought' and an almost-obligatory 'testing' pullback. It's possible that the pullback ended over the past few days at the 50-day MA, but it would take a decline to the vicinity of the 200-day MA to get us interested in new buying.



The reason we are currently reticent to increase exposure to uranium-mining stocks is that the uranium price hasn't yet begun to rally. In fact, over the past week the uranium price dropped back to last year's low, which means that it is at its lowest price of the past 8 years.

We think the stock market is right to anticipate a substantial rise in the uranium price, but we will need to see some evidence that the uranium price has turned the corner before adding to our uranium-mining exposure.

The Stock Market

In our 2014 forecast for the US stock market (as represented by the S&P500 Index) we outlined what we considered to be the two most likely scenarios. Here is an excerpt from our Yearly Forecast that describes these scenarios:

"The first scenario is that a major peak is forming right now. Under this scenario the ultimate price high will occur this month [January], after which the market will gradually roll over to the downside. Weakness during the first half of the year will be relatively minor, but downward acceleration will occur during the second half of the year after it becomes clear that "QE" has failed to bring about a sustained economic recovery.

This scenario is consistent with a) the extreme optimism reflected by sentiment indicators over the past month, b) the market's high average valuation, and c) the past year's decline in the rate of money-supply growth. It is also consistent with the likelihood of economic data remaining generally supportive for at least a few more months.

The second scenario involves some 'corrective' activity during the first two months of the year followed by a final surge to the ultimate high during April-May. In addition to being consistent with the same influences as the first scenario, this scenario also meshes with the Presidential Cycle Model [the PC Model predicts a high during April followed by a downward trend to an October bottom]."

We then wrote:

"Of our two scenarios, at this time we favour the second. The main reason is that although the US monetary inflation rate has trended lower over the past year, it has not yet dropped to levels that preceded the bursting of previous investment bubbles."

The first scenario was eliminated at the end of February, but the second scenario is not only still in play it is still, in our opinion, the most likely outcome.

There are two things that could happen this month to further increase the probability of a high of at least intermediate-term importance, the first being a surge by the SPX to near the top of the channel drawn on the following daily chart (around 1950). Becoming this stretched to the upside would almost certainly set the scene for a multi-week pullback and the pullback could evolve into something substantial.



While a surge by the SPX to near its channel top would increase the probability that a major top was being put in place, it is not a prerequisite for such a top. However, a divergence between indices and/or relative strength indicators is a prerequisite for a major top. A significant divergence is therefore the second thing that could, and SHOULD, happen at around the time of a major top.

A potential divergence would be a new high for the year in the SPX that isn't confirmed by a new high for the year in the NASDAQ100 Index (NDX). Another would be a new high in the SPX that isn't confirmed by a new high in the RUT/SPX ratio (small-cap stocks relative to large-cap stocks).

The RUT/SPX ratio's current situation is depicted below. The move by the SPX to a new high at the end of February was confirmed by a marginal new high in the RUT/SPX ratio, but notice that at this stage the RUT/SPX ratio has fallen well short of confirming the SPX's latest move to a new high.



Gold and the Dollar

Gold

The following chart compares the daily closing levels of the US$ gold price and the HUI/gold ratio over the past 6 months. Our reason for including this chart is to show that there has recently been a bullish divergence and that this divergence is similar to the one that occurred just prior to the 31st December bottom in the gold market.

The divergence doesn't imply that the correction is over, but it does imply that there won't be much additional downside.



Gold's correction is probably not yet complete. However, the relative strength in the gold-stock indices over the past 5 trading days suggests that an initial low is in place and that the completion of the correction will more likely encompass a successful test of the initial low than a decisive new low. In other words, the rebound that has just begun will probably be followed by a decline that results in a successful test of this week's low.

Gold Stocks

Short-term upward trends in the gold-mining sector have been characterised by relative strength in the juniors, as indicated by a rising GDXJ/GDX ratio, and short-term downward trends in the gold-mining sector have been characterised by relative weakness in the juniors, as indicated by a falling GDXJ/GDX ratio. With this in mind and with the benefit of hindsight, it is clear that the failure of the GDXJ/GDX ratio to confirm March's upside breakout in the HUI was a bearish divergence and a warning that the breakout was not going to be sustained.



Although the GDXJ/GDX ratio rebounded on Wednesday 2nd April, it made a new low for the move on the preceding day and has not yet signaled an end to the correction. However, the recent bullish divergence between the gold-mining sector and the gold price -- as discussed above -- suggests that there isn't much additional downside potential. As is the case with gold bullion, the decline that follows the current rebound is more likely to result in a successful test of the low than a decisive break to a new low.

We have been frustrated by the recent pullback in the gold-mining sector. Not because stock prices have fallen too far, but because with one exception (RIOM) the stocks we wanted to buy haven't fallen far enough. We have several under-the-market buy orders in place, but up until now only one of these orders (a small addition to our RIOM position) has been filled. Other buy orders that are presently under-the-market will possibly be filled if the gold-stock indices test their lows later this month.

The only gold stocks that we are interested in buying right now are producers that are profitable at the current gold price (e.g., EDV.TO, EVN.AX, RIOM) and explorers/developers with strong balance sheets and projects that have exceptional exploration potential and/or would likely be economically viable at the current gold price (e.g., AAU, LYD.TO, PG.TO, PLG.TO). We will consider riskier stocks for new buying after we become confident that the correction is over.

The Currency Market

Over the past 3 years we have generally been either neutral or bearish on commodities (as represented by the CCI) and commodity currencies on both short and intermediate-term bases. However, early this year we started getting more optimistic in anticipation of intermediate-term rallies. With regard to the Australian Dollar (A$), an intermediate-term rally probably got underway in January.

If we are right to assume that gold bottomed in December-2013 then the A$'s upward reversal in January-2014 continues a lead-lag relationship that has existed since early last year. We are referring to the fact that over the past 13 months the A$ has followed gold with a delay of between 3 weeks and 7 weeks.

The relationship is illustrated on the chart displayed below. The blue boxes on the chart show the time from a reversal or a trend acceleration in the gold market and a similar event in the A$ market.



A literal interpretation of the above chart would indicate that a significant A$ pullback lasting at least 1 month (the lagged response to gold's recent correction) will begin within the next couple of weeks, but the chart's main message is that if gold goes on to make new highs for the year over the next few months then it will be reasonable to assume that the A$ remains in an intermediate-term upward trend.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.uxc.com/