Stocktake: ‘Flash crash’ tale of spoofing makes little sense

Investors find it hard to believe that the 2010 ‘flash crash’, which saw US indices suddenly collapse in value before quickly recovering, was caused by a London trader living with his parents.

People are right to be perplexed. Authorities have accused Navinder Sarao of "spoofing" – placing bogus sell orders in an effort to mislead other traders into thinking a big seller was active. Spoofing may be manipulative, but it's commonplace. Typically, spoofers get fined, so Sarao must have been shocked to learn he faces a maximum 380-year jail sentence.

Regulators say Sarao used such strategies on hundreds of other days. There was but one flash crash, of course, not hundreds. His strategy was seemingly designed to outwit high-frequency trading (HFT) algorithms – to outspoof the spoofers – rather than unleash market mayhem. Not only that, Sarao’s algorithm was actually switched off at the time the flash crash happened.

Why, asks finance professor John Cochrane, is Sarao being prosecuted "and not all the people who wrote badly programmed algorithms that were so easily spoofed".

Indeed. If the world’s largest equity market can be destabilised by one tracksuit-wearing, stay-at-home day-trader, then we really should be worried.

Is the oil bear market over?

Oil prices have risen by almost a quarter since March. Is it a dead cat bounce or does it herald the end of the oil bear market?

Oil continues to look cheap compared to stocks. The ratio between the S&P 500 and US crude oil hit a 13-year high last month, Merrill Lynch noted recently.

Despite oil’s rebound, the indicator still remains some 40 per cent above its 30-year average.

Of course, one could argue the ratio indicates not that oil is underpriced, but that stocks are overpriced.

However, history is on the side of oil bulls. Since 1983, there have been 12 episodes where oil prices rallied 25 per cent off a one-year low.

Three months later, according to Nautilus Research, prices were higher on nine occasions, with gains averaging 11.7 per cent.

A year later, prices were also higher on nine occasions, and the gains tended to be big – on average, prices were 32 per cent higher.

Markets gripped by indecision

US bulls are losing faith, but there’s no cause for panic – the bears are also in retreat.

Recent American Association of Individual Investors polls show the percentage of investors describing themselves as either bullish or bearish is well below historical norms.

In contrast, 45 per cent have a neutral outlook on the market, the highest reading in 26 years.

This indecision is reflected in the S&P 500 remaining stuck in a tight trading range. Over the last 50 days, the distance between the index's low and high points is just 3.78 per cent, according to money manager Dana Lyons.

The average 50-day range is nearly three times as great. In fact, the current range is tighter than 97 per cent of readings since 1950.

According to RBC Capital Markets, the least volatile months of the year are from April to July inclusive. Traders in search of action, it seems, should look elsewhere over the coming months.

Buy dogs, not darlings

Hated stocks are thrashing market darlings. Over the last year, a portfolio of the 10 stocks that were most overweighed in large-cap portfolios fell by 2.3 per cent, according to a recent Merrill Lynch note. In contrast, the least popular names soared by 29.3 per cent.

Contrarians have long preached the virtues of buying unloved stocks, but the current performance gap is especially stark. The cause, Merrill suggests, is the flood of money out of actively managed funds and into passive index funds.

Fund outflows are forcing managers to cut holdings in their favoured stocks. Passive funds don’t have favourites; they buy all the stocks in an index, resulting in increased buying interest in unpopular names.

With money continuing to flow into passive funds, contrarians will be expecting a repeat performance this year. Buy dogs, not darlings.

Fat cats and hipsters

Scottish craft brewery

BrewDog

last week launched Equity for Punks IV, a crowdfunding scheme that aims to raise a record £25 million (€35 million) to help fund its expansion.

Fans of BrewDog beers can buy shares in the fast-growing company, allowing it to steer clear of financiers, whose focus on profits “gave rise to the bastardisation and commoditisation of beer”.

Somewhat immodestly, BrewDog says it is “burning the established system”, and “putting the fat cats out to pasture and empowering everyone to be masters of their own destiny by investing in our passion for craft beer”.

Stirring stuff! No doubt, BrewDog’s self-congratulatory message will go down well with its hipster base.

However, BrewDog is valuing itself at some £280 million (€390 million) – more than 70 times last year’s operating profit. City “fat cats”, no doubt, will approve.