As more and more quants focus on trading exclusively with themselves, and the slow and vanilla money piggy backs to low-vol market swings, the aberrations become self-fulfilling. What retail investors fail to acknowledge is that the quants close out a majority of their ultra-short term positions at the end of each trading day, meaning that the vanilla money is stuck as a hot potato bagholder to what can only be classified as an unprecedented ponzi scheme. As the overall market volume is substantially lower now than it has been in the recent past, this strategy has in fact been working and will likely continue to do so... until it fails and we witness a repeat of the August 2007 quant failure events... at which point the market, just like Madoff, will become the emperor revealing its utter lack of clothing.
So what happens in a world where the very core of the capital markets system is gradually deleveraging to a point where maintaining a liquid and orderly market becomes impossible: large swings on low volume, massive bid-offer spreads, huge trading costs, inability to clear and numerous failed trades. When the quant deleveraging finally catches up with the market, the consequences will likely be unprecedented, with dramatic dislocations leading the market both higher and lower on record volatility. Furthermore, high convexity names such as double and triple negative ETFs, which are massively disbalanced with regard to underlying values after recent trading patterns, will see shifts which will make the November SRS jump to $250 seem like child's play.
For readers curious about just how relevant liquidity is in the current market, I recommend another recent post that discusses DE Shaw's opinion on the infamous basis trade, in which their conclusion was that establishing a basis trade, which is effectively the equivalent of selling a put option on market liquidity, ended up in massive financial carnage as the market rolled from one side of the trade to another. Is it possible that what the basis trade was for credit markets (most notably Citadel, Merrill and Boaz Weinstein), so the quant unwind will be to equity markets?
So when will all this occur? The quant trader I spoke to would not commit himself to any specific time frame but noted that a date as early as next Monday could be a veritable D-day. His advice on a list of possible harbingers: continued deleveraging in quant funds as per the charts noted above, significant pre-market volatility swings as quants rebalance their end of day positions, increasing principal program trading by Goldman Sachs on decreasing relative overall trading volumes, ongoing index VWAP dislocations. One thing is for certain: the longer the divergence between real volume trading/liquidity and absolute market changes persists, the more memorable the ensuing market liquidity event will be. At the end of the day, despite the pronouncements by the administration and more and more sell-side analysts that the market is merely chasing the rebound in fundamentals in what has all of a sudden become a V-shaped recovery, the "rally" could simply be explained by technical factor driven capital-liquidity aberrations, which will continue at most for mere weeks if not days.
http://zerohedge.blogspot.com/2009/04/incredibly-shrinking-market-liquidity.html
I'm convinced that ZH is one of the best market blogs out there, but this is honestly a little over my head to fully digest.