Market is dominated by speculation

The stock market has always been a speculative playground, with irrational movements sometimes lasting for years. Since many investors are lead to believe that financial markets are “efficient” and “forward-looking”, I wanted to illustrate a few features of the current market which demonstrate a high degree of speculative activity.

1. Stock exchange activity has speculative characteristics

A notable trend both in American and Canadian stock markets has been the rapidly increasing volume of leveraged ETFs, which are derivative-based products used for leveraged day trading speculation. Products like FAZ and UYG (leveraged financials) which only appeared a few months ago have rapidly grown in daily volume to the point where they routinely appear among the highest volume stocks traded in a day.

The volume on the leveraged/inverse ETFs is simply crazy, considering these are exclusively day trading vehicles with virtually no longer-term investment use. For example, among today's NYSE 25 most active stocks, there were 7 leveraged ETFs. FAZ (3x financials) was the #8 most active stock and is often even higher in the list. Among Canada's most active stocks, 2 of the 10 most active stocks are leveraged commodity funds. HNU (2x natural gas) was the most active stock with considerably more volume than the ten year old XIU, which is Canada's benchmark index ETF. This brand new leveraged ETF has more volume than all the big Canadian banks combined, even on a stellar day for banks.

When looking at those figures, one has to conclude that leveraged (derivatives-based) ETFs have a very significant share of all stock exchange activity. Routinely, the leveraged ETFs trade more dollars than all the well-established stocks! This is a totally new phenomenon in 2009 and has never been seen before in stock markets, so it is obviously not well studied. I can guarantee you that this will have interesting consequences for market history.

The leveraged ETFs are exclusively used for day trading or short-term speculation, so this tells us right away that a major part of all stock market activity is short term speculation. But even when you look at the other most active stocks, you find more signs of rampant short-term trading.

August has turned interesting because many of the highest volume stocks are trading a large percent of their float (public shares outstanding) within single trading days. Just by skimming the NYSE's most active stocks, I found the following major financial stocks turning over a huge amount of their float.

NYSE stock

Trading day

Volume (shares)

Float (public shares)

% of float traded


August 27

149.03 million

119.65 million



August 24

831.42 million

1.11 billion



August 5

292.48 million

390.83 million



August 10

393.42 million

647.14 million



August 5

2.67 billion

5.44 billion


These are just some examples. There have been many days in August where these and other “most active” stocks have traded an incredible percent of all their public shares and accounted for much of the NYSE volume. Whoever is moving stocks like FNM, FRE, C, AIG or CIT can not possibly be long-term “buy and hold” investors when 50% to 100% of all public shares are changing hands in one day! Therefore, these financial stocks and many others are being priced and moved by speculative trading.

So let's take a second look now at a typical August trading day such as today. Of the 25 most active NYSE stocks,

These obviously speculative stocks add up to 2.46 billion shares volume, which is 38% of the total NYSE volume (6.56 billion shares). I didn't even search around for an extreme day, yesterday would have been even more extreme. That's an incredible amount of money being moved purely in leveraged ETFs and stocks which (through August) are trading abnormally large proportions of their float.

2. Bank profits are mostly from speculation and trading

The general consensus seems to be that the worst is over for the banks. The positive quarterly results are cited as evidence of the recovery. Royal Bank of Canada today reported “record third quarter results”, and headlines cheer the huge profits. Earlier, the results from JP Morgan impressed America: “JPMorgan Chase posted a $2.7 billion quarterly profit on Thursday, showing its turnaround” wrote the New York Times.

Ignoring for now the health of their balance sheet and off-balance sheet derivative exposure, let's take a closer look at the earnings from these two giant North American banks:

JP Morgan Chase business segment

Net Income 2Q09

Net Income 2Q08

1 year change

Investment Bank




Retail Financial Services




Card Services




Commercial Banking




Treasury & Securities Services




Asset Management




Corporate/Private Equity







Pay attention to the 1 year change column, which shows how JP Morgan Chase's current earnings compare to a year ago, before the storm began. Notice that there are only two segments showing improvements, both of them with enormous increases from 2008.

Clearly, the investment banking division accounts for most of JPM's net income. Looking back over many quarters, you can see that this is a new phenomenon since the first quarter of 2009 – investment banking is the dominant factor in JPM earnings in 2009.

Investment Bank earnings are broken down further to reveal that most of the earnings come from investment banking fees and “Principal transactions” especially in “Fixed income markets”. This was also the case in the first quarter, but definitely not the case before 2009.

But what about “Corporate/Private Equity”, the other major source of earnings and a huge increase from a year ago? Detail for those earnings show that the earnings come almost exclusively from “Principal transactions” which suddenly increased in the second quarter of 2009 (never before were they at these levels).

The JPM glossary describes “Principal transactions” as “Realized and unrealized gains and losses from trading activities … and changes in fair value associated with financial instruments held by the Investment Bank...”

Do you see what this means? JPM makes all of its money in trading, especially in fixed income (and derivatives) trading. JPM is not making money in retail banking or credit cards: they are making money in trading and increasing asset values.

Royal Bank of Canada segment

Net Income 3Q09

Net Income 3Q08

1 year change

Canadian Banking




Wealth Management








International Banking




Capital Markets




Corporate Support







Let's take a look next at Royal Bank of Canada (their fiscal third quarter ends July 31). Notice that banking segments have experienced a decline in net incomes from one year ago. But the reason for Royal Bank's impressive results today? A leap in net income from “Capital Markets” and to a lesser extent, “Corporate Support”. The earnings release attributes the strong results in Capital Markets to “stronger trading revenue particularly in UK, US and Canadian fixed income and money markets”.

Looking at further detail of the Capital Markets segment shows that this one year jump in net income is entirely attributable to “Capital Markets Sales and Trading”. Another table in the quarterly earnings shows total trading revenue at the bank: $1.6 billion this quarter versus just $385 million a year ago. Now take a look at the amazing jump over the 9 month period. For November 2007 through July 2008 (before the storm), total trading revenue was $648 million. But for November 2008 through July 2009, trading revenue was $3.7 billion, nearly a six-fold increase in trading revenue.

How about that “Corporate Support” segment, which is the only other segment contributing to the strong earnings? The financial statements are deliberately vague about this segment, but I notice in the annual report that Corporate Support, just like Capital Markets, has “debt held-for-trading” which includes treasuries, corporate bonds, and mortgage-backed securities.

Uh-oh... the Corporate Support segment also basically speculates in fixed income. Royal Bank of Canada is only making in trading, especially in fixed income. Sound familiar? This is the same story as JP Morgan. Also note that these levels of trading, and the revenues seen, are unprecedented before 2009.

The annual reports from these banks always make me laugh. The front pages show photos of seniors, young families, and university students. You could almost believe that the banks are operating in classical lending and deposits. But here's the ugly truth: the banks are only making money because they are aggressively gambling in financial markets, especially in fixed income and interest rate derivatives. The 2009 earnings show this very clearly to anyone who bothers to look.

3. Mainstream media advice is speculative in nature

The mainstream media currently offers investment advice in the following forms:

a) “Cash in a bank account doesn't earn anything, so take a chance on stocks.”

Translation: Instead of researching and evaluating whether stocks are under or over-valued, buy stocks only because there is a chance they will return more than 0% (cash). Ignore the possibility of capital loss.

b) “Investing aggressively, especially in the fastest rising sectors (financials), gives you the chance to make significant profits and erase your earlier losses.”

Translation: Gamble that you can ride the current bull trend for a great % profit to erase your earlier severe losses. This is like increasing your bet at the gambling table in the desperate attempt to make everything back on a lucky break.

Implications of a market dominated by speculation

The market action since autumn 2008 has been increasingly speculative, and has stepped up in 2009 with some truly bizarre patterns. The current market appears to even more speculative and disconnected from financial results and earnings – stocks with declining earnings are actually rallying more than stocks with rising earnings (see Bloomberg article). Leveraged derivatives-based ETFs are dominating stock exchange volume for the first time in history, and much of the remaining volume comes from distressed financial stocks trading much of their public float every day in August. These are speculators chasing returns and looking for quick profits.

Not to mention, the much-hyped “recovery” in banks appears to be due to their windfall profits in market (fixed income) trading, not improvements in loan performance. This is not just a qualitative assessment; the quarterly earnings clearly show that bank earnings are only up for segments which focus on trading and market speculation.

A very speculative market is dangerous because it is prone to swift reversals and sharp declines. If the current market participants causing this rise are just seeking large short-term gains, then when conditions reverse the market will become a very unbalanced playing field with everyone on the sell side and nobody willing to buy. Short sellers normally balance the market because they are willing to buy a weak market, but now that regulators have scared away traders from this market-stabilizing activity, I really think the market will become a scary place when stocks weaken.

- Perpetual Bull