When logic and proportion have fallen sloppy dead

And the white knight is talking backwards

And the red queen’s off with her head…

Grace Slick, White Rabbit

‘Twas brilling, and the slithy toves

Did gyre and gimble in the wabe:

All mimsy were the borogoves,

And the mome raths ougrabe

Lewis Carrol, Jabberwocky

 

For those of a certain age there is little mystery as to Grace Slick’s inspiration for White Rabbit. Or at least we don’t think so but then things are not always as we perceive them to be. Alice in Wonderland, the story that is the inspiration for Grace Slick’s composition, can be seen as merely a nonsensical children’s story. Or as a warning about the inevitable loss of one’s innocence. Or as a cautionary tale about the sometimes meaningless and nonsensical puzzles that life presents us and the futility of trying to solve them. So was Grace Slick singing about the psychedelia of the sixties or just longing for the innocence of her childhood or shamelessly pandering to an audience to sell records? With the myth that has grown up around the song, we are unlikely to ever know the truth. As for Jabberwocky, a poem that appears in the sequel to the original Alice story, I don’t have any idea what Carrol was getting at with that bit of whimsy. Sometimes nonsense is just nonsense.

I thought of Lewis Carrol and his rabbit holes this week upon reading of the arrest of Navinder Singh Sarao, a London trader the SEC and CFTC have charged with precipitating the “flash crash” of 2010. Now, when I write “London trader” that conjures images of “the city”, big trading floors, European hedge funds and tea at the club, but that is an image distorted by the funhouse mirror of our preconceived notions. Sarao traded from home using nothing more than some slightly modified, off the shelf trading software. Well, not exactly; he actually traded from his parent’s house which is nowhere near “the city” but rather closer to Heathrow and no, a neighborhood near the airport is no more desirable in London than it is in any other city. Are we to believe that one man, using easily obtainable software, working alone from his parent’s suburban home – possibly while wearing nothing more than his pajamas – and backed with a modest bankroll was able to bring the US stock market to its knees? According to US financial regulators, yes, you should absolutely believe that little nonsensical tale.

If that doesn’t make you feel like you’ve fallen down the rabbit hole – and scare the hell out of you – consider what else we’ve learned about Mr. Sarao since his arrest. His trading company has exactly one employee, Mr. Sarao himself. He started with a relatively modest amount of capital and managed to run up a fortune of roughly $40 million in the last 6 years – and park it in various tax havens around the world all from the comfort of his bedroom. Despite having that kind of bank, his mother continued to work two jobs; Mr. Sarao has been described as someone who likes making money but not spending it – even on his mum apparently. Neighbors said they often saw his family around the neighborhood but rarely saw Mr. Sarao himself; he was essentially a recluse. His bail has been set at 5 million pounds and despite the seriousness of the charges against him and the time it may take to come to trial he might want to consider the possibility that jail would be preferable to facing the wrath of his mother.

Does any of this matter to the average investor or is it just nonsense on stilts? If our financial system has become so brittle, so fragile, that a lone insomniac trader, working in the wee hours, far away from the trading desks and trading floors – and the prying eyes of regulators – can cause such a dislocation in the stock market – albeit a very short lived one – then this is far from nonsense. If the markets upon which we rely to allocate scarce capital can be gamed – for nothing more than the thrill of the game in this case it seems – then the very foundation of our capitalist system is at risk. For it is confidence, faith that the system is fair, that is at the root of any capitalist system and once lost – if it hasn’t been already – it will be very hard to restore. Consider too that if one man can cause this kind of havoc almost offhandedly, imagine what a group determined to bring down the system might accomplish. Based on what I’ve read so far – and all of it is conjecture at this point – Mr. Sarao managed to turn the high frequency trading systems against themselves – a kind of financial judo –  and in the process appears to have found a tipping point, that one grain of sand that sent the pile into free-fall. That it hasn’t happened since would appear to be nothing more than sheer luck. It certainly isn’t the dogged oversight of the SEC.

Another possibility is that the regulators still don’t know exactly what is going on and Mr. Sarao is nothing more than a patsy, a fall guy, a scapegoat offered up as proof that the regulators are on the job protecting the public from nefarious hackers and other ne’er-do-wells. That, unfortunately, seems to be a better explanation than that the SEC and CFTC have any idea what actually happened, who was at fault and whether any laws were broken. If anything, it appears to me that, by understanding the methods of the HFTs, Mr. Sarao found a way to spoof the spoofers. I’m not condoning it but good luck to the SEC and CFTC convincing a jury that anything unlawful took place. In fact, good luck explaining it at all.

Another aspect of this, about which I’ve seen no commentary, is the impact on the economy. What is the cost to the economy, to society, when a person of Mr. Sarao’s obvious abilities chooses to earn his living by extracting what amounts to a form of economic rent from a flawed financial system? Why, as technology has advanced, has the financial system become less productive rather than more efficient? Considering that he is far from the only one engaged in this activity and he was able to extract $40 million working from his parent’s basement, how much is the global tax on capital imposed by HFT practitioners and other financial system hackers? For that matter, consider that Mr. Sarao himself has said that most of his net worth was gained in just 20 trading days and the rest of the 6 years was basically spent goofing off. How much damage could he have done if he was really trying?

There has been much about the last 6 years that has an Alice in Wonderland feel to it. The great divide, the chasm between a sober economic reality and a stock market exuberance has never been greater than today. Last week again produced a variety of economic data, little of which should have been comforting to the bulls and yet the uninterrupted, artificial nature of the bull market continued as if the Fed has produced some kind of mushroom that forces traders to see all data through rose colored glasses. There should be no doubt now, after months of weak data, the US economy has slowed dramatically in the first quarter of the year. And yet, hope springs eternal for the second half acceleration and the market indicators I watch most closely for advance warning of recession – the yield curve and credit spreads – show no sign that anyone expects anything but blue skies ahead.

It seems that expectations have now solidified around the idea that this year will look exactly like last year when a 1st quarter contraction was followed by two robust quarters – or at least quarters that could be viewed that way out of context – and a slide into the now familiar 2 to 2.5% growth rate by the 4th quarter. But there are differences this year that should make one skeptical of that story arc and its happy ending. Most prominently, inventories continued to build in the first quarter – unlike last year – and it is looking more and more as if the second quarter is going to look a lot like the first. In addition, the investment side of the economy does not look nearly as healthy as it did this time last year. The cut in capex in the energy sector is biting and biting hard. The recent stabilization in oil prices may provide a respite but the glory days of drill, baby, drill appear to be past and not coming back anytime soon. The US economy is facing its toughest test since the last recession and the outcome is far from assured.

Almost as surreal is the emerging confidence about growth prospects in Europe where Germany is not only the engine of growth but also the passenger car and the caboose. I’ve owned European equities since the summer of 2012 when everyone hated them but the bandwagon is now nearing capacity – in fact there are bulls hanging off the sides –  and I find myself looking for alternatives to Europe and the US in a world where there aren’t many. Asia still offers the best growth prospects and while they aren’t as cheap as they were, stocks there are a bargain compared to the US and Europe. Fears about China continue to dominate the commentary on Asia which gives me some comfort from a contrarian standpoint although I must admit to worrying a bit about the Middle Kingdom myself. Japan’s economy is still a mess but at least corporate earnings are showing healthy growth, at least in Yen. So I think a continued exposure to Asia makes sense.

But if one really wants to act the contrarian, the asset classes that evoke revulsion most easily are emerging markets and commodities, which are in some ways related. The overwhelming consensus is that the US Dollar is going higher and commodities, being generally inversely correlated, are going lower. Add in the fears of a continued slowdown in China and the fan club for emerging markets and commodities, both of which are reckoned to be dependent on Chinese demand,  could meet in an airplane bathroom. But if the US economy continues to slow – and that is looking more likely – but avoids outright recession, the dollar is likely to pull back and with it the pressure that has been put on emerging market economies. As for China, I think the bears forget sometimes that slower growth in China does not mean no growth and in fact probably amounts to a number most countries would kill for.

We may be down the rabbit hole but logic and proportion aren’t completely dead. Investing is still about fear and greed and the ability to recognize and overcome those emotions. It is in some ways about doing what Navinder Singh Sarao did to the high frequency traders – recognizing and taking advantage of the herd instinct that drives markets. What he did was try to spook the herd, to drive it in the direction he wanted it to go. Our job is easier; we just want to keep from getting trampled. To do that one must merely “gyre and gimble in the wabe”. Nothing to it.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.