Don't Believe The Rally?

I wanted to follow-up on my previous post where Leo de Bever articulated his fears on what will happen when the music stops. Joe Saluzzi, co-founder of Themis Trading, was interviewed on Yahoo Tech Ticker on Monday (see video below):

Major averages are hovering near their highest levels since September 2008, but retail investors continue to flee the market.

Domestic equity funds have suffered outflows for 24 consecutive weeks through Friday, and over $81 billion has come out of domestic equity mutual funds year to date, according to Morningstar.

At the risk of stating the obvious, several factors explain why investors simply don't trust the rally.

Twice bitten, thrice shy: Having been burned by the bursting of the tech stock bubble in 2000, the housing bubble and the financial crisis of 2008, investors are understandably wary of getting sucked in again. A "lost decade" for index investors hasn't helped either.

It's the Economy Stupid: With the "real" unemployment rate near 17%, millions of Americans simply have no money to put into the market; many are cashing out their 401(k) plans and otherwise raiding their nest eggs in an effort to stay afloat.

Given the economic backdrop, it's no surprise many investors see the rally as being detached from reality and due only to the Fed's easy money policies...and the promise of more!

"We're not seeing any sort of growth other than stimulus," says Joseph Saluzzi, co-founder of Themis Trading. "That is a very disturbing thing -- the constant stimulus that keeps on coming that really does nothing other than barely keep you above [breakeven] on the GDP print."

In addition, Saluzzi says investors are rightfully worried about a market dominated by "high-speed guys just chasing each other up and down the price ladder."

Unsafe at High Speeds

As has been widely reported, high-frequency trading routinely accounts for more than 50% of daily U.S. equity trading volume and regularly approaches 70%.

Saluzzi isn't opposed to high-frequency trading per se, calling it a "byproduct of the market structure," as detailed in the accompanying video. But he believes that structure is broken, thanks to rules promoting computer-driven trading, most notably Reg NMS.

As a result of regulatory changes and new technology, events like the May 6 ‘flash crash' "will happen again," he says. "There's not a doubt in my mind."

Many retail investors feel the same way, another reason for the mistrust of the rally and why about $65 billion of the equity fund outflows this year have occurred in the five months since the "flash crash".

So are high frequency trading (HFT) platforms accounting for 70% of the daily trading volume? I'm not sure if it's that high but I have no doubt that today's stock market is primarily driven by multi-million dollar computers developed by large hedge funds and big banks' prop desks.

And what's the best way to beat high frequency trading? Take a long-run view on a stock, a sector, or an asset class. You're never going to beat the computers day trading but you can make money in these markets by understanding the weakness of these HFT platforms. For example, if you hold shares of a solid company and the price plunges on high volume for no real valid reason, chances are some HFT is going on in that company. My advice is to add to your positions on those dips and just hold on. If you get cute, placing tight stop losses, you're going get burned. Just like anything else, computers have advantages and disadvantages.

[Note: Keep an eye on Citigroup (C), a favorite target of HFTs, and Research in Motion (RIMM). Both stocks are primed to break out from these levels. I prefer RIMM.]

What worries me more is what Saluzzi says on how volatility is impacting the IPO market. But the facts don't back up his claims. In fact, according to Renaissance Capital, $23 billion was raised in the global IPO market last week, making it the biggest week this year and signaling a revival in investor interest for this class of equities:

The Hong Kong offering of AIA, a carveout of AIG's Asia Pacific life-insurance business, raised $17.8 billion, making it the fifth-largest IPO on record. Also Taiwan's TPK Holdings has a $200 million IPO; the firm is the supplier of the touch-screen technology behind Apple's iPad.

In early November, Coal India IPO is set to raise more than $3 billion in what may be the country's largest-ever initial public offering.

In the U.S., handbag-maker Vera Bradley (VRA), Chinese education provider TAL Education (XRS) and Italian restaurant chain Bravo Brio (BBRG) raised a combined $440 million, while in South America, oil and gas provider HRT Participações sold $1.4 billion in new stock on Thursday.

Norway’s Statoil Fuel & Retail raised $800 million after pricing at the top of the range Thursday. Andthe world's largest online betting exchange, London-based Betfair, made its public debut by raising $540 million.

The average 2010 IPO has returned 6.3% from its first day close to date, outpacing the 4.8% year-to-date return of the MSCI World Index (IWRD), says Renaissance.

“Heavy, deal flow, positive returns and a swelling IPO pipeline suggest an active close to an already active year, and an IPO market that has finally returned to more normalized issuance levels,” the company said in an online blog.

As for the economy, don't just focus on the US. CPB Netherlands Bureau for Economic Policy Analysis released its world trade report on Monday, showing world trade up 1.5% month-on-month in August and world industrial production up 0.2%:

Compared to its long run average, production momentum remains high in July, particularly in the United States, the Euro Area, and emerging Asia.

There is a lot of slack in the US economy, but things are slowly shifting. As for the rally, there is plenty of liquidity to propel shares much higher. While I understand asset managers who are skeptical, I fear they will be left in the dust when the markets start going parabolic. And whether or not you believe in the rally, it's irrelevant. What is relevant is how long can you afford to underperform the markets before you lose your job?