The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

2019

02/19/2019

Recognizing the stock market and the economy are two different things, I am more worried about the stock market this year than the economy, and here’s why:

First, automated trading by algorithms is already well over 70% of all trades on the NYSE.  Some estimates are as high as 90%.  There is nothing inherently dangerous about a formula, that says “if this, then do that.”  Absolutely, there will always be  some “fat-finger” formula that causes momentary disruptions in the market.  However, my fear is that artificial intelligence (AI) is now seeping into the algorithms.  Someday, AI may be great but not yet.  After all, it was an AI error that put the Lion Air plane into the sea near Indonesia last October, killing 189 people.  AI is exciting but is not ready for prime time.  AI can do far greater damage than algorithms.  Unfortunately, there is a strong first-mover advantage (think:  big profits) to being the first trader to fully adopt AI.

Second, dark pools are huge pools of liquid assets held inside huge institutions, where big clients can trade stocks among themselves, without the public markets knowing about it.  This price discovery is usually delayed only one day, but that could easily translate into huge profits for somebody.  Big investors moving into or out of companies are also invisible for a period of time, which is an unfair advantage for somebody.  Unconfirmed estimates are that dark pools have increased almost 50% over the past year.  When the stock market becomes  less transparent for a reason, it is not a good reason.

Third, the continuing tsunami of new exchange-traded funds (ETFs) could pose a liquidity problem in a small crash, leading to a big crash.  Last year, there were 954 new ETFs, while 479 were closed or terminated.  If there is a mini-crash, ETFs are very different from traditional mutual funds.  When investors sell a mutual fund, the fund manager simply sells enough underlying stocks to raise cash.  It is very unlikely a fund manager could not sell the underlying stocks.  However, when investors sell an ETF, the investor must find a buyer for the ETF, not the underlying stocks.  It is a stock that owns other stocks.  It is not a question of selling the underlying stocks, like mutual funds.  Thinly-traded ETFs might not sell at all, at any price.  (Remember 479 ETFs closed in 2008 alone.)  An ETF investor could find he cannot sell his ETF.  An old Wall Street adage is “if you can’t sell what you what, sell what you can.”  A mini-crash could mutate into something more serious.

Lastly, while it is repeated too often, the geopolitics of 2019 are especially worrisome.  Nobody knows what a hard BREXIT will be like for the world’s second largest financial center.  Also, the looming Italian debt problem will make the Greece problem look downright pleasant.  In the U.S., corporate debt is at a an all-time high, and they have over $700 billion due this year.  Plus, how will the President handle the debt ceiling negotiations after March 1st?  In addition, he will almost certainly be impeached this year.  While he will not be convicted, the headlines will continue to grind on investors.  More moving pieces than normal!  In fact, too many!!

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