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March 09, 2007

Rise of the (Selling) Machines
by Michael Panzner

In the popular 1984 film, The Terminator, current California governor and former actor Arnold Schwarzenegger plays a cyborg sent back in time to eliminate the mother of future leader John Connor before he could be born. Single-minded and highly developed, the robotic killer relentlessly pursues his intended prey throughout the movie, despite strong resistance from the hero's supporters, although the good guys eventually win out in the end.

While the story is pure fantasy, some may not realize that in the stock market there are the equivalent of dangerous man-made automatons lurking in every corner. Often technology-based, they are powerful, sophisticated, and difficult to keep under complete control. Yet they are exerting a growing and pervasive influence on prices. Unfortunately, these potential share-price assassins, if they were to be suddenly unleashed all at once, represent a Terminator-like threat to financial markets, especially if conditions are just right.

Like they are now, when the economy is rolling over and share prices have already begun to correct from historically overvalued and overbought extremes.

First among the potentially destructive creations are exchange-traded funds, or ETFs, which have become a significant feature of the modern investment landscape. Far too significant, some would say.

Recent research from Prudential Equity, for instance, suggests that buying and selling in three small cap ETFs is having a sizeable impact on certain stocks in the Russell 2000 index. By their reckoning, activity in Barclays Global Investors' iShares Russell 2000, iShares Russell 2000 Value, and iShares Russell 2000 Growth index funds accounts for 20% to 40% of turnover in some smaller issues, according to the Wall Street Journal.

Like index-related arbitrage and other forms of basket-type trading, such activity is not driven by fundamentals in the traditional, Graham-and-Dodd sense, but instead reflects the rapidly expanding role of various technical, arbitrage, thematic, and macro-type investing strategies.

The problem is that while some of this "price insensitive" trading -- not based, in other words, on stock-specific information or insight -- has been a boon for equity markets in recent years amid gushing liquidity and a mad dash for incremental returns, the negative consequences for prices as credit, economic, and investment cycles turn for the worse could be considerable.

Under the circumstances, index-related selling, for example, could transform markets in thinly-traded securities that have been unusually liquid and serene into boggy swamps of illiquidity. This would spur widespread fear and even a sense of panic, along with a substantial increase in volatility, as hordes of investors scramble nervously towards the exits.

The broad use of chart-based, trend-following, and momentum-driven trading and investing strategies is also likely to exacerbate the market's woes in the face of a sustained downturn. With fear a more powerful motivating force than greed, the herding behavior that such methods naturally encourage will likely create a snowball effect that will be hard for anyone -- either those diving in or those bailing out -- to resist.

Other modern risk-management methods and tactics will also fan the bearish flames once former long-term bull markets start coming apart at the seams. These include the widespread use of high-powered statistical and computerized models that measure and help manage risk exposure using data derived from recent market behavior. When trading conditions are serene, firms can take on more risk; if prices start swinging wildly, they must cut back on their exposure, which often means selling into a falling market.

In the past, corrections and full-fledged bear markets have been accompanied by significant price gyrations and converging correlations between different products, sectors, and markets. When that happens in an environment like we have now, where there are numerous large institutions with complex and highly-leveraged bets in myriad markets, it creates the potential for a seemingly relentless death spiral where selling leads to increased volatility, begetting further selling.

There is also the unsettling and potentially destabilizing fallout from the growing use of portfolio-based margining and risk management strategies. Aside from the sudden and unwelcome appearance of gaps between expected and actual risk of loss, rising illiquidity in some markets will force many participants to try and sell positions or hedge themselves in others that remain accessible, causing additional markets to quickly buckle under the pressure.

Another potential source of destructive energy will likely stem from capital flows linked to gyrations in foreign exchange markets, a far-reaching reassessment of trade policies in the face of slowing growth around the world, and the unwinding of global financial imbalances that are already at unsustainable extremes.

Moreover, during uncertain times, history suggests that investors tend to favor repatriating funds that are invested overseas, regardless of whether the decision makes sense in the long term.

Finally, a dramatic increase in outstanding derivatives exposure, especially in recent years, suggests that violent crosswinds associated with speculation, hedging, and unwinding will wrack the underlying assets. Formerly deep out-of-the-money and structural long-term derivatives positions that were once thought to require little oversight will suddenly demand active risk management, as will exposure taken on in more recent times.

Overall, there are myriad signs that the economic winds are shifting and a bearish darkness is settling over the investment landscape. It's worth remembering, of course, that when the share-price Terminator shows up, he won't just be a character in a movie.

Michael J. Panzner
financialarmageddon.com

Michael J. Panzner is a 25-year veteran of the global stock, bond, and currency markets and the author of Financial Armageddon: Protecting Your Future from Four Impending Catastrophes, published by Kaplan Publishing.

Copyright © 2005-2007 Michael J. Panzner

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