Sunday, August 30, 2009

More on the Massive Trading Volumes in Troubled Financial Stocks

This story began for me with simple reader inquiries concerning a stock market indicator called TRIN and their perceptions that TRIN was "broken". For the uninitiated, TRIN assesses the proportion of stock exchange volume that is going to advancing stocks to the volume attributable to declining issues. When TRIN is below 1.0, it means that volume is relatively concentrated in rising shares; above 1.0 means that volume is concentrated in declining stocks.

TRIN appeared to be broken because we were getting huge swings in its values from moment to moment in the market. It would swing wildly, sometimes going far above 1.0 and sometimes far below. I pointed out that, from a purely mathematical vantage point, this could only occur if a disproportionate share of NYSE volume was occurring in one or a handful of stocks.

Further inquiry revealed that this was, indeed, the case: I found that, not only were the trading volumes of such stocks as C, AIG, FNM, and FRE elevated, as noted the by Big Picture blog, but that their composite volumes (their volumes traded across all exchanges) exceeded that of all other NYSE stock trading! Indeed, I discovered that the 20-day TRIN was at its lowest level since 2000 because volume was highly concentrated in rising stocks. This was not just unusually heavy volume; it was unusually heavy to the buy side.

Since this volume was directional--all of these stocks had made spectacular percentage gains--and because the highly unusual activity was unique to troubled financial firms (not stable companies such as GS and JPM), I surmised that something might be afoot: a systematic attempt to bolster the shares of taxpayer supported companies that--for political reasons--could not return to the bailout well. Why such an attempt? Perhaps to reimburse the largest shareholder of the institutions and position these companies to raise capital on their own. They certainly weren't going to raise their own capital as languishing two-dollar zombie stocks.

Of late, we've seen articles in the mainstream media suggesting that the volatility in these troubled financial companies' shares is attributable to short-covering. "When large numbers of short sellers close their positions by buying shares at the same time, the stocks involved can register explosive - and often inexplicable - gains," the Financial Times article explains.

On the surface, this makes sense. The S.E.C. has been toying with the idea of reinstated curbs on short selling, and this could spark short covering among financial firms. Indeed, according to the ShortSqueeze site, C, AIG, FNM, and FRE have large short positions as of the most recent report, amounting to approximately 11%, 20%, 6%, and 10% of their total floats respectively.

Once we look at the magnitude of the recent activity in these stocks, however, the idea that this rise is largely a function of short covering becomes implausible. As we see with Citigroup (C) stock (top chart) and AIG, FNM, and FRE (bottom chart), the August trading volume alone has exceeded the total floats of these companies--and certainly their total short interests--by factors of 4 or more. While short covering no doubt has contributed to the rise in these shares, traders and investors could have covered every single short position and still not accounted for the lion's share of recent activity in the stocks.

We also hear the idea from the mainstream media that some of the huge volumes in these stocks can be attributed to "daytraders". This conjures images of young guys in proprietary trading shops churning trades all day long. I know or work with a number of the largest discretionary prop firms in the country and am aware of none with the capitalization to pull off trading volumes of this magnitude. It boggles the imagination that, suddenly in August, daytraders across the country began trading volumes of shares in excess of total NYSE volume. Again, I have no doubt that daytraders have been playing these stocks and contributing to their rally; I just cannot see them as primary drivers of such activity.

The fact that the August trading volumes in C, AIG, FNM, and FRE far exceed their total floats also suggests that individual large buyers of these companies are not driving their rise. To achieve volumes of this staggering magnitude, some kind of churning of shares must be occurring--not just block purchases over time. The only kind of trading technology I know of that is capable of such churning is high frequency, algorithmic trading. This was also the recent conclusion of Zero Hedge. Firms engaging in such strategies, including some of the largest investment banks, do indeed have the capital to trade such volumes.

Of course, these high frequency trading programs are supposed to be market making only, not drivers of directional market moves. As a federal prosecutor noted when there was an alleged theft of some of these programs, however, such technology can "manipulate markets in unfair ways".

Are these bailout beneficiaries now enjoying the fruits of market manipulations? I don't know the answer to that, but I find it interesting that none of the principals of the firms appears to care. According to a recent article, the chair of Freddie Mac indicated that he had "no idea" what these trading volumes were all about. The article also noted that, "Representatives for Fannie, the SEC, AIG, FINRA and the NYSE declined to comment. Spokeswomen for Treasury, which owns most of AIG, and the Federal Housing Finance Agency, which holds Fannie and Freddie in conservatorship, also wouldn't comment."

Somehow I think if the tables were turned and huge volumes were being executed on the *short* side to drop the share values of these companies, we would hear a renewed hue and cry about manipulated markets and the need to curb rapacious short sellers. When there is unprecedented volume lifting the shares of seemingly worthless companies in a manner that could only be accomplished by the directional programming of trading systems, company officials and financial regulators appear to be silent lambs.

I don't have answers to many of these puzzling observations; I do recognize good questions worthy of inquiry. If we're not getting comment from authorities and the firms themselves, where is the investigative financial press? Bland assurances that we're merely seeing heightened short covering and daytrading activity simply don't pass muster.

I will be tracking this story during the week ahead; follow my tweets for updates.

Disclosure: I do not hold long or short positions in any of the above mentioned stocks and have not held positions in any of them during 2008 or 2009.