Beating the Flash Boys

April 17, 2014

  • Office Space meets Wall Street: How HFT is intercepting your trades… and why…
  • Most of the bargains on Wall Street have been snapped up… but here’s why they aren’t too expensive to buy…
  • China’s wolfish demand for gold can’t be stopped: Why the gold price is drowning in its own blood despite it…
  • The “federal Caribbean paradise of Guantanamo”… why drones are nothing new… a reader weighs in on taxing the rocket sauce… and more!

  “Listen, that virus you’re always talking about,” Peter says to a colleague in the hit comedy Office Space.

“The one that could rip off the company for a bunch of money…”

“Yeah? What about it?” his colleague, Michael asks.

“Well, how does it work?”

“What it does is every time there’s a bank transaction where interest is computed… thousands a day… the computer ends up with these fractions of a cent, which it usually rounds off.

“What this does is it takes those little remainders and puts it into your account.”

“This sounds familiar,” says Peter.

  If you’ve had a close watch on the spin of the financial newsreel the past couple weeks, this virus will sound undoubtedly familiar to you, too…

If not, we’ll do our best to get you up to speed.

Our familiarity with this virus — and the reason the Office Space scene popped in our minds this morning — is in large part due to the recent release of famed financial author Michael Lewis’ newest book, Flash Boys.

His book, if you don’t know, is all about what’s called high-frequency trading, or HFT.

As mentioned, there’s no shortage of news floating around on the topic. Especially after the release of Flash Boys: The book deftly untangles the knotty issue and breaks it down into an easy-to-understand — even entertaining (not to mention shocking) — read.

“If you own stock,” reads one mainstream review by way of example, “you need to read Flash Boys… and then call your broker.”

 We picked up a copy as soon as it hit the shelves and thumbed through (we suggest you wait to pick up yours, though. We’ll explain why in a moment)…

“The U.S. stock market now trades inside black boxes,” the introduction reads, getting to the crux of the book, “in heavily guarded buildings in New Jersey and Chicago. What goes on inside those black boxes is hard to say — the ticker tape that runs across the bottom of cable TV screens captures only the tiniest fraction of what occurs in the stock markets… even an expert cannot say what exactly happens inside them, or when it happens, or why.

“The average investor has no hope of knowing, of course, even the little he needs to know,” Lewis writes. “He logs onto his TD Ameritrade or E-Trade or Schwab account, enters a ticker symbol of some stock and clicks an icon that says ‘Buy’: Then what? He may think he knows what happens after he presses the key on his computer keyboard, but trust me, he does not.

“If he did, he’d think twice before he pressed it.”

He’d think twice because, as Lewis explains in his book, the average investor is getting hit with a “virus” similar, in effect, to that used by the disgruntled workers in Office Space.

The only difference, of course, is that the HFT “virus” is real… very real.

  “The stock market can often seem like a casino,” our own Chris Mayer chimes in on today’s lead subject, “or worse, a rigged casino.

“Especially with all this talk about high-frequency trading.”

HFT, Chris explains, is the term used when “traders use computers programs to swap stocks at speeds 100 times faster than the blink of an eye. The firms using this technology have spent billions to gain an edge of just milliseconds over everybody else.”

This infinitesimal edge gives HFT firms the ability to skim billions of dollars by taking a tiny fraction from every trade.

Should you care? Certainly.

Should you be worried? Let’s see…

  “Think of it this way,” our Lifetime Income Report editor Neil George writes, weighing in: “Say you tell your broker to buy 1,000 shares of Facebook.

“Then a HFT computer sees your order coming and instantly executes its own buy orders before they happen. By the time your trade goes through, Facebook’s stock price could be a few cents higher — all thanks to a computer that knew what you were about to do and had the ability to take advantage of it.

“Since the computer’s order will increase the stock’s bid price,” Neil writes, “the computer is essentially able to buy the stock for less than what the regular investors will pay.

“Now, losing a few cents to a computer may not sound like a big deal. But multiply this by every transaction you make. Imagine every time you go to buy or sell a stock, some big company jumps in front of you, taking a small part of your profits just because they have the power and money to do so.”

But before you grab your pitchfork, says Neil, “The regulators can’t do anything about it. If they crack down on things like private trading and HFT, the firms will simply go outside the United States. That means fewer U.S. financial firms, fewer jobs and fewer dollars flowing to local Bentley dealers and such.

“So all the outrage in the world isn’t going to stop the big-money guys from taking profits from you one penny at a time. Instead, you just need to use their biggest advantage against them.”

[Ed. note: That’s precisely what we set out to accomplish in our latest project — to show you how to use a Flash Boy’s strengths against them and come out on top. The markets are closed tomorrow for Good Friday, so The 5 will take a break too. But we’d never think to leave you empty-handed: Watch your inbox on Friday for a special opportunity. We’ll show you how… in just five words… you can beat the Boys at their own game. Stay tuned…]

  Upon writing, the markets are swinging after a smorgasbord of earnings reports this morning.

The Dow just whipped down 20 points, to 16,405. The Nasdaq is flat at 4,086. The S&P is down a quarter of a point at 4,085.

Gold and silver are marching sideways: gold down a dollar, to $1,300, and silver unchanged at $19.64.

  “Most of the bargains are gone in the stock market,” Jonas Elmerraji reports from our trading desk.

“But,” he hedges, “there’s a difference between saying that the dirt-cheap, insane bargains of recent years have disappeared and saying that stocks are too expensive and overpriced to buy today. Sure, stocks are expensive-ish, but that’s not the same as saying they’re expensive.

“One of the most common measures of how expensive stocks are is the price-earnings ratio. The P/E ratio measures a stock’s price compared with its per share earnings. Put another way, it tells you how many years of earnings you’re paying for in advance when you buy a stock.

“Historically, the index’s average P/E ratio has weighed in at 15.5 — higher means that stocks are more expensive than average, and lower means they’re cheaper.

“So with a P/E ratio of 17.3 as I write, the S&P 500 is more expensive than average. But not by much.

“In fact, the big stock indexes would need to more than double from here to reach the insane multiples that got hit before 1999’s market top.

“Irrational exuberance this ain’t.”

Jonas recently told his readers to forget momentum stocks… oil discovery riches… biotech drug approval pops… and even hot IPOs. Instead, he suggests, click here to see where the real money is made.

  “China’s appetite for physical gold remains insatiable,” our 5 PRO pacesetter Dan Amoss updates.

“According to the China Gold Association, 2013 consumption rose by 41% year over year, to a record of 1,176 tons. That’s impressive. Even more impressive is another indicator of demand…”

The Shanghai Gold Exchange is another way to measure the real total demand for gold in China, so reminded the CLSA strategist Chris Wood in a recent report.

“On this point,” Woods writes, “gold withdrawals from the SGE vaults rose by 93%, to 2,197 tons, in 2013, according to the exchange. It should be noted that imported and mined gold are required to be sold first through the SGE.”

  So what bludgeoned China’s wolfish demand and sent the price lower?

“It’s a fact that in a secondary market (like stocks),” says Dan, “for every buyer of an asset, there has to be a seller. That’s why you should ignore the market cheerleaders’ comments about ‘cash on the sidelines’ or money ‘going into or out of’ an asset class.

“Such comments assume there’s just one side in a two-way market. The urgency of the investor to buy or sell relative to the urgency of the other party determines price.”

Why the lower price, then? “Our guess,” says Dan, “is the liquidation from gold ETFs in the U.S.

“The decline in GLD exceeded the decline in gold futures in several instances last year,” he explains. “This in turn led to shrinkage of GLD shares outstanding and redemption of physical gold held in by the custodian. The custodian sold physical (and shrank the GLD share count) to prevent GLD from diverting too far from the futures price.

“Exacerbated by high-frequency traders, demand for GLD changes at light speed — much faster than physical gold demand in China. This helps explain why GLD had an outsized negative influence on the gold price in 2013.

“In 2014, however,” Dan concludes, “the liquidation of physical gold from ETFs has slowed.”

More on that to come. If you’re a PRO member, be sure to check out today’s edition below on two buys in the gold space.

  While the Internet may’ve killed the video star… the “selfie” is resurrecting one throwback pastime: the printed picture.

One study, conducted by camera equipment insurer Photoguard, included a poll of 1,000 amateur and professional photographers. Nearly half said they had not printed off any pictures. This half consisted mostly of people who favored taking pictures of art and food — not selfies.

But the other half — the selfie-shooter — on the other hand, is of a new breed: “More than 80% of people who said who said they took ‘selfies’ had also printed off their snaps in the past year,” the Belfast Telegraph reports, citing the study.

And now, whether you like it or not, you know.

  “For your reader who suggested that we citizens could audit government agencies and demand a refund,” a reader writes in response to yesterday’s mailbag, “the government would like to inform you that your temporary office awaits you at the federal Caribbean paradise of Guantanamo. (Heh…)

“When you get there, be sure to say hi to the person who came up with the bumper sticker that says, ‘ Lee Harvey Oswald, where are you when we need you?'”

  “Everybody’s talking drone,” another writes, pivoting to drones, “but is this something really new? The answer is… no!

“For decades, amateurs have been flying plane and helicopter models of any size, powered before with gas engines, now with batteries, that have good performance and are less noisy.

“So ‘drones’ are not something new. The only thing that is new is the way we use them. Miniaturized cameras can now be packed better on small planes, as an example. So 20 years ago, it was possible to do bad things with flying models….”

  “Come on, Dave!” another writes, this time about our segment yesterday on the rocket sauce and Uncle Sam.

“Beer and taxes in the same sentence? To coin your own phrase, you often use, ‘Oy!’ I had to chuckle, barely, when you gave the not including sales tax disclosure about your map and rankings of the states’ ‘sin tax’ on beer.

“Well, there you go. No wonder my Washington (the state, not D.C.) was down there at No. 24. I believe if you add in our exorbitant sales tax, close to 10%, Washington would make the top 10. So the occasional visit to our neighbor to the south, Oregon, sitting at No. 45 — with no sales tax — is, err, well, hmm???

“Oh, yeah, strictly for medicinal purposes.

“Hey, can’t you write off medical-related expenses? Hmm, need to ask the accountant about that one!

“Always — well, most of the time — enjoy The 5.”


Chris Campbell
The 5 Min. Forecast

P.S. “I can’t decide whether China’s about to turn around… or if it’s on the verge of triggering the biggest crisis since the Panic of 2008,” says The 5’s Dave Gonigam, still sorting out the ideas that gushed forth yesterday afternoon at a gathering of all the far-flung Agora Financial editors here in Baltimore.

“Nor is that the only thing to chew on,” Dave goes on. “We also got a glimpse at how biblical ‘codes’ hint at market cycles, and a big dose of inflation might be just around the corner. And yours truly made the connection between one of our all-time favorite mainstream media meltdowns and the possibility of owning farmland with a few mouse clicks in your discount brokerage account.

“Rest assured we’ll explore all these issues and much more in the weeks and months ahead here in The 5.”

P.P.S. But all that’ll have to wait until next week. As mentioned, the markets are closed tomorrow… and thus, The 5 follows in their footsteps. We’ll be back on Saturday with your 5 Things. And your regularly scheduled weekday programming will resume on Monday.

In the meantime, keep your eyes peeled tomorrow for a special opportunity we’ve cooked up. It’s all about HFT and how you can beat the Flash Boys at their own gambit. ‘Til then, stay tuned…


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