Market manipulation: Which is easier to game, issues or indices?

Generally speaking, the Ben-Stein-o-sphere is one corner of the financial internet from which I’m delighted to absent myself. Yves Smith is more courageous than I am in that regard, and while strolling the mean streets, he offers the following conjecture:

It is one thing to move the prices of single securities, quite another to move entire markets, particularly ones as big as the global equity markets and the US credit markets. We must have a simply staggering number of traders all conspiring together.

That’s a perfectly commonsensical thing to say. But is it true? I don’t know, but I think it’s a fascinating question. Here’s the pro and con as I see it:

Pro: By analogy with price impact behavior on individual securities, market indices should be well-nigh impossible to move. Generally speaking, the price impact of transactions is inversely related to the dollar trading volume of the traded issue and positively related to its volatility. It’s much easier to move a thinly traded small-cap whose value has recently ranged all over the map than to move, say GE. Broad indices are by definition diversified (which reduces volatility), and the dollar trading volume of index components is gargantuan. Ergo, it should be very difficult to move indices.

Con: Perhaps the analogy between indices and issues is misleading. Indices can be traded as though they were single issues, via ETFs and futures, for example. But the market for such instruments is fragmented, and trading in any one is orders of magnitude thinner than the volume of the overall market it mimcs. An ETF or index future would be hard to move not so much by virtue of its own depth, but because it is bound by arbitrage to the price of the market as a whole. But the market as a whole has a great many degrees of freedom, and many stocks whose “true” values are uncertain. If one wants to materially move the price of a single issue, one probably has to push against “informed valuation” by investors who specialize in the stock’s industry and are willing to take bets on relative pricing. But if one pushes against a whole index, arbitrage constraints can be resolved my moving many stocks only slightly, each issue remaining within the bounds of what would be considered noise by those who might trade a deeper mispricing. There’s an elegance to this approach, in that the market itself determines an optimal path to resolve the disconnect created by the manipulator. Stocks for which there is a great deal of valuation uncertainty would move more than those whose prospects are clear, and the market manipulator avoids the transaction costs of trading these tens or hundreds of relatively illiquid issues herself. (Price-weighted or equal-weighted indices would be more vulnerable than value-weighted indices to this sort of attack, as smaller / less liquid / more volatile stocks have disproportionate sway.)

That’s a nice theory, but would it work? I have no idea. If anyone out there has any insight into the question, hypothetically speaking of course, please do comment. It is frequently suggested that, while individual stock prices may be manipulable in the short-term, broad markets are immune. Is that right?


4 Responses to “Market manipulation: Which is easier to game, issues or indices?”

  1. groucho writes:

    Steve, are you familiar with Engdahl’s work?

    “What was significant about the October 1987 one-day crash was not the size of the fall. It was the fact that the Fed, unannounced to the public, intervened through Greenspan’s trusted New York bank cronies at J.P. Morgan and elsewhere on October 20 to manipulate a stock recovery through use of new financial instruments called derivatives.

    The visible cause of the October 1987 market recovery was when the Chicago-based MMI future (Major Market Index) of NYSE blue chip stocks began to trade at a premium, midday Tuesday, at a time when one after another Dow stock had been closed down for trading.

    The meltdown began to reverse. Arbitrageurs bought the underlying stocks, re-opening them, and sold the MMI futures at a premium. It was later found that only about 800 contracts bought in the MMI futures was sufficient to create the premium and start the recovery. Greenspan and his New York cronies had engineered a manipulated recovery using the same derivatives trading models in reverse. It was the dawn of the era of financial derivatives.”

  2. Aaron Krowne writes:

    Something like two-thirds of all trading volume in the major equities markets is now programme trading by hedge funds and proprietary trading desks. They are typically ten to one hundred times leveraged relative to base capital, so it is easy to see how they might have an outsized effect relative to their investment-assets market share.

    These agents make heavy use of indicies to implement hedging and inter-market arbitrage strategies.

    It is quite possible that there is so much trading “pressure” on indicies that underlying issues are regularly “dragged around” by their noses to follow. In other words, in a sense, the indicies may have become more “primary” than underlying issues.

    This jibes with much I have been seeing and hearing. I’ve seen GLD move four times more than gold itself in a day. I regularly hear reports of strange inefficient bids coming out of nowhere and moving the market aggressively (a-la the 1987 anecdote above). Strong sector moves quite often happen in conflict with specific events for underlying issues (e.g. homebuilders or banks uniformly rallying including some players for whom negative news has come out).

    I think this thesis of the “primacy of indicies” is quite plausible when one looks at the balance of volume over indicies as compared with individual issues. They are all first-class securities; the relationship between them is merely second-order. They are priced directly based on their bids and asks; the relationship of ask x on issue X to bid y on index Y is by no means direct or deterministic. Especially not in the short term.

  3. Aaron Krowne writes:

    To answer your question by the way, I’d say yes, entire markets are highly gameable, probably moreso than ever.

    A factor I didn’t emphasize is that programme trading all too often is based on the same core technical trading fundamentals “everyone” uses. The theory goes that an intent manipulator can simply wait for the “resistance” or “support” lines, and then either aggressively buy or sell around that point to have an outsized influence. “Create the market move you want to see”.

    If you have just a few large/highly-leveraged hedge funds doing technical/quantitative trading you could crash (or rally) an entire market or sector. Once you induce a distinct move, even if it is small, many other technical and quantitative traders will “pile on” and magnify the effect.

    Of course this just generates longer-term arb opportunities. What one would expect to see emerge from this picture is higher volatility.

  4. groucho writes:

    Steve, Aaron, Sprott Asset management did a nice piece on the PPT back in 2005