Are Stock Prices Real Any More?

One wonders if stock prices are real.  Consider the evidence.  Due to political obtuseness, the U.S. barely avoided defaulting on its debt.  The economy continues to expand at a disappointing rate.  Employment growth is tepid.  Middle class incomes are falling, on average.  Consumers are gloomy.  The Federal Reserve Board is gloomier.  Businesses hold back on investing cash.  But, last week, the S&P 500 reached record heights.  When you encounter cognitive dissonance in the financial markets, be careful.  Every time in the past 20 years when things seemed out of whack, it eventually turned out that, in fact, they were out of whack.  In other words, if it looks too good to be true, it probably isn't true.

Could investors be wearing their stupid hats again?  Their 401(k)'s got clobbered in the 2000-01 tech stock crash, and after adjustment for inflation, stocks still haven't recovered.  Investors' 401(k)'s and homes got clobbered again in the financial crisis of 2008, and many haven't recovered from those losses.  What does it take to move up the learning curve?

Maybe, however, the problem isn't investors.  Over 50% of the trading volume in the stock markets comes from high-speed computerized trading.  This activity isn't based on human judgments.  It flows from algorithms and formulae.  Some of the computerized trading is dynamic--it changes based on what it observes in the market.  Since the activity it is often observing is computerized, we now have computers reacting to the activity of computers, which could be reactions to activity by other computers. 

When stocks were valued by humans, we had some idea of what we were dealing with.  Even if things seemed irrational or even bubbly, we could understand what was happening, albeit with a frown.  Now, with stocks being priced by "thought" processes that are impenetrable to the average investor, the market not longer reflects the collective judgment of humans.  Instead, it is an amalgamation of valuation processes that often aren't based on human judgment.  The things that people are concerned with--lousy economy, sluggish jobs growth, falling incomes, dim view of the future--may not be finding their way into stock valuations, at least not in the ways that they historically did.  If so, we can't be sure stock prices are real because we have no idea what the computers will do next.  Caveat emptor.

Knightmare in the Financial Markets

Knight Capital's announcement today that it lost $440 million yesterday (Wednesday, Aug. 1, 2012) when its trading system went haywire illustrates the potentially dramatic consequences of computerized trading. Details on exactly what happened remain scarce. But it appears that trading volume at Knight spiked for some 30 to 45 minutes at many strange prices. A large number of trades were cancelled. Broker-dealers that normally route orders to Knight have temporarily ceased to send it business until the air is cleared.

Knight opened for trading this morning, saying that it still complied with regulatory capital requirements. Nevertheless, its capital position is reportedly not pretty, and news stories indicate that it's seeking a capital infusion, plus an emergency loan from a major bank. Knight may not survive if it doesn't establish confidence among the broker-dealer community within a day or two.

And that's the really scary thing about the Knight debacle. It's conceivable that Knight could have been rendered immediately insolvent if its big trading glitch had lasted a bit longer, or had involved a somewhat larger number of transactions. Such an insolvency would have impacted Knight's counterparties, possibly imperiling them if their exposures to Knight were large enough. If these counterparties had become insolvent, the financial miasma could have spread and other firms knocked down like falling dominoes. All this, potentially, because of less than an hour's computerized trading gone haywire.

The risk of insolvency in such a situation could be heightened by the fact that other market participants might observe such a debacle in real time and pull their accounts before the trading day ended. This, were it to occur, would amount to a run on Knight. Now that the financial community knows that Knight (and perhaps its competitors) can become imperiled within an hour's time, they might be all the quicker to grab for their money first, and ask questions later. The quaint display of depositor anxiety so sentimentally portrayed in It's A Wonderful Life would be a mere box car compared to the Maserati of broker-dealer flight in our world of computerized trading.

Sadly, regulators would probably have little or no idea of what would be going on. The SEC recently adopted rules for a consolidated audit trail with a requirement to report trades to the agency. But the new rules call for next day reporting to the SEC. The agency wouldn't be able to track in real time what the cannoli was going on, and hence would be behind the curve as market participants cut and ran.

Of course, the Federal Reserve would jump in with bailout checks for one and all of the imperiled firms if a meltdown of the financial system loomed. But the availability of desperation-driven, last ditch bailouts offers little comfort. More than ever, market participants and regulators need to get a handle on computerized trading. The ability of computers to execute vast numbers of ridiculous trades without any constraint is really, truly, seriously dangerous. By all indications, the financial markets are now operating on a sudden death basis. That cannot end well.

The SEC Tackling Computerized Trading

More than half of all stock market trading is now done by computers. It was inevitable that the SEC would bring enforcement cases involving computerized trading. Late last week, the agency imposed administrative sanctions on a money manager named AXA Rosenberg, for allegedly misleading its clients about a software malfunction in the firm's trading software. AXA Rosenberg managed a "quant" fund that invested based on computer analysis of a variety of factors. According to the SEC, the computer software's risk management process did not work properly, resulting in over $200 million of losses. When AXA Rosenberg personnel uncovered the problem, they did not disclose it to clients when they should have, and instead misled investors by claiming the losses were due to market volatility. Among other things, AXA Rosenberg will pay a $25 million penalty. More importantly, it's reportedly lost over half the money it had under management, as investors apparently headed for the exits after news of the software problem came out. That must have really hurt. Other quant funds will take notice.

Although the AXA Rosenberg case concerns today's elaborate computerized trading, it is a straightforward application of the federal securities laws. Investors were told that their money would be invested through the use of computer algorithms and other computerized analysis, and the law dictates that they must also be informed of risks presented by material defects and deficiencies in the programming. Disclosure of risks has been required since the beginnings of the federal securities laws, and as far as legal theory goes, the AXA Rosenberg case is as traditional as fireworks on the Fourth of July.

The SEC faces much bigger problems with computerized trading, as illustrated by the Flash Crash of May 6, 2010. That day, the Dow Jones Industrial Average dropped 9% in a matter of minutes, only to recover after a few more minutes. Apparently, a large computer-driven sell order by a money manager triggered other selling by computers monitoring the market, which soon led to wide-spread computerized stock dumping. This kind of high-speed chaos, like turning a corner on a highway and driving right into a sandstorm, scared the bejesus out of investors and still keeps droves of them away from the market in spite of the ongoing bull run.

Computerized trading is based on relative price movements: stocks are bought or sold when prices in the near term appear as if they are about to rise or fall. The software senses that a stock is comparatively cheap, and sends out a buy order. Or it senses that a stock is comparatively expensive, and sends out a sell or short sell order. Then, if and when the market moves the way anticipated by the software, the computer then closes out the trade by ordering a sell or buy, respectively. All of this happens very quickly, sometimes in milliseconds.

Trading based on perceptions of relative prices is nothing new. Day traders and other short term speculators have, for generations, tried to profit from relative price movements. Many money managers trying to beat market averages invest based on their perceptions of relative price. But computers have taken it to an entirely new level. With the ability to trade in milliseconds, computers can sense and profit from a price trend before humans have time to blink. Computers probably trade with other computers most of the time and the price movements they attempt to exploit may well be caused by other computerized trading. Sentient beings (i.e., humans) are simply left behind.

But the heart of the stock market isn't found in the upswings and downswings caused by relative price changes. It's in the overarching, long term gains (and losses) reflected in the valuations, perhaps seemingly subjective and imprecise, sentient humans place on stocks over the course of years and decades. Without sentient pricing, if you will, the stock market wouldn't exist. No one would risk their savings in a market where the only hope of profit would be relative price changes based on the short term inclinations of whoever or whatever else might happen to be in the market at the moment.

The real challenge for the SEC will be to preserve sentient pricing's fundamental role in the stock markets. High speed computerized trading to exploit relative price changes cannot take primacy over the human element in the stock market. There will be times when the agency may want to limit or slow down the participation of computerized trading. Such measures would find precedent in historical stock market limits on index arbitrage trading (like the New York Stock Exchange's collars and sidecars). Possibly, position or transactional limits on the size or amounts of some kinds of computerized trading might be necessary to prevent a single firm from smacking the market too hard one way or the other. Other measures, depending on the state of the art of computerized trading, may also be in order.

It's one thing for a computer to beat a human in chess, or even in Jeopardy. But when computers beat humans with the humans' retirement savings at risk, we have a horse of a different color. The "secondary" market, as the day-to-day stock market is called in Wall Street parlance, exists to support the capital formation process and not to serve as a speculators' mosh pit. An entire generation of investors fled stocks after the 1929 Crash, and it's no accident that stocks did not recover their losses from that crash until 1954, 25 years later. Ultimately, what counts is the absolute value of stocks, and human investors are needed to sustain absolute value.

How Liquidity Can Be Bad for Investors

It is axiomatic among finance professionals that liquid investments are preferred for individual investors, especially those that aren't wealthy. It's easier to buy and sell liquid stocks and bonds. Information about them is easier to get. They tend to have readily ascertainable values.

But these qualities, especially the ease of buying and selling, make liquid investments the focus of computerized trading. Computers can observe prices, and buy or sell stocks, all in milliseconds. Their great speed allows them to profit from holding stocks for just a moment. It's not unusual for a computerized trading system to complete a purchase and sale of a stock in ten seconds or less.

All this frenzied computerized activity requires highly liquid markets. The program has to be able to trade quickly at or very near, the prices the computer observes. Otherwise, the algorithm (i.e., the mathematical formula) on which the program is based won't work well, and, horror of horrors, money could be lost.

So the banks, hedge funds and other institutional investors deploying computer-driven trading strategies have come to dominate the markets for the most liquid investments. Over half the trading in the stock markets today is computer-driven. The small investor, who thoughtfully researches investments before timorously buying a couple hundred shares, is playing on an interstate filled with tractor trailers. For little apparent reason other than a deluge of lickety split orders spewed out by immensely powerful computer systems, investors can lose 10% or more in a matter of minutes. This happened during the flash crash on May 6, 2010. It could happen again.

The markets for the most liquid of stocks and bonds are beginning to look like commodities markets, where positions are bought and sold for momentary profit, and where the big, powerful traders garner almost all the profits. The Model T version of investing--buying and holding--is taking on a distinct resemblance to the Tin Lizzy.

The stock markets have always favored the big firms and large investors. Small investors (a/k/a chumps) have always been at a disadvantage. But there once was, or at least seemed to be, something in it for Mom and Pop. Today, however, the stock market, unadjusted for inflation, is trading about where it stood in April 1999. That's 11 years ago. Factor in inflation, and we're back to mid-1997, 13 years ago. Either way, that's a long time with no gains. The Moms and Pops who put faith in CDs and money markets came out ahead.

Individual investors have largely stayed out of the most recent bull market. The last few weeks' volatility will only reinforce their skittishness. They know that, should they ever get the urge to go back into stocks, they'll never beat a computer to the punch. Why put your hard-earned savings into a market where you're behind the competition and have no hope of catching up?

High tech traders argue that computerized trading adds liquidity to the market and therefore is beneficial. They overlook that fact that long term buy and hold investors (so-called "natural" investors in market parlance) are the true fount of liquidity. Drive them out, and the market, and we, will be poorer for it.

The Complexities of Computerized Stock Trading: We Told You So

Life gives you very few chances to say "we told you so." So you take the opportunities you get. It appears that today's abrupt 998 intraday point plunge in the Dow (which partially recovered to close down 347) was the result of computerized stock trading programs selling so fast they tripped over each other, and then interpreted the resulting mess as a signal to sell more. Things snowballed. See the explanation from the New York Stock Exchange. http://www.bloomberg.com/apps/news?pid=20601087&sid=aETiygQQ8Y3g&pos=1.

This is a problem we predicted last fall. http://blogger.uncleleosden.com/2009/10/computerized-stock-trading-grave-new.html. Nothing's been done since then, by the exchanges and other markets, big banks and other securities firms, FINRA, or the SEC. The NYSE announced it will cancel trades that were more than 60% above or below the 2:40 p.m. Eastern Time price. It appears that if you make a truly big mistake in the stock markets, you get a second chance. And when you buy stocks at a really cheap price, you can be punished for being astute. When computer programs are inadequate to spot a pile of dog doo on the sidewalk and rush to buy it, they (and the well-capitalized hedge funds and broker-dealers that use them) shouldn't be let off the hook. Make them pay the price of their mistakes and they'll fix their computer programs. Give them a bailout, and what incentive would they have to prevent this from happening in the future?

Too bad all those millions of folks whose 401(k) accounts got clobbered in 2008 didn't get a second chance.

Computerized Stock Trading: A Grave New World?

The nature of the stock markets is changing. More than half today's trading volume comes from computer-directed transactions. This mostly consists of ultra-fast trades of vast quantities of stocks. Prices can be quoted and transactions completed in milliseconds, before the human eye can begin to comprehend the quote. There are, in essence, two different markets--one taking place on a superfast scale between computers, and the horse-drawn buggy market for those slow-poke humans. In such a scenario, the market pros that own the computers are likely to get the best prices, and mom and pop investors trying to put aside 100K or 200K for their modest retirements may be left with table scraps.

Many of the computerized trading firms are financed with ultra cheap credit provided courtesy of the Federal Reserve. The Fed's zero interest rate policy provides an incentive to speculate, making risk taking appear more attractive. Indeed, current Fed rumblings about withdrawing accommodation may only increase stock speculation. If you know the Fed might take the bargain basement credit away at any moment, you wouldn't invest long term, or even medium term, in something so mundane as, say, America's manufacturing capacity. Lose your cheap financing and the deal that looked so good a few months ago may turn out to be junk. Instead, it's better to jump in and out of stocks on a minute by minute or even second by second basis, laying off your risk before the Fed has a chance to mess up your profit potential. It may be that, in their innermost thoughts, the Fed's governors want an exuberant stock market, since it takes a lot of political pressure off of them. But lasting recoveries won't come from stock bubbles.

Then, there is the possibility that the computers are distorting prices. Back in the days when Leave It to Beaver was broadcast on prime time TV and human beings determined stock prices through their collective desires to buy and sell, there was no limit on the factors that might influence prices. While the fortunes of each company issuing stock most directly affected the price of its stock, politics, war, weather, currency fluctuations, interest rate changes, government policies and a host of other factors affected stock prices. No computer program, however many variables are incorporated into the algorithm on which it is based, can completely replicate the infinitude and variation of factors that humans would consider relevant to a stock's price. Recall the vaunted risk management systems used by Wall Street earlier this decade to evaluate the chances of a downturn in the real estate markets. By all indications, virtually none of these systems got it right. The possibility of downside real estate risk on a national level seems to have been programmed out of the computers. This would have been a human programming error, but computers cannot self-correct for programming errors.

With the flood of computerized trading now hitting the market, we must wonder whether we'll have deja vu all over again. It may be possible for one computerized trading system to miscomprehend prices and send out a torrent of orders that appears to another computer system to be anomalies that provide trading opportunities. The second system then sends out its own torrent of orders to take advantage of the perceived "anomalies," which in turn may appear to other computerized trading systems as "mispricing" that should be hit with buy, sell and short sell orders in the next two nanoseconds before the pot of gold disappears into the maw of another firm's computers. In this mosh pit of computer vs. computer, prices may drift away from fundamentals, and eventually that would turn out to be a bad and painful thing.

There's a chance the SEC will clamp down on some of the most unfair aspects of computerized trading. But it would have a hard time, legally and philosophically, prohibiting high speed, computerized trading. Abstractly speaking, people should be able to innovate through the use of computers. But the large-scale, hyper fast trading that we have today runs the risk of making smaller, long term investors feel like they are simply grist for the big boys' mills. That would only fuel the populist streak in today's efforts at regulatory reform. Wall Street's current short term trading profits could lead to long term increased regulation. We know that many on the Street take the view that while the music is playing, you have to get up and dance. But the last time Wall Street did a collective hokey pokey with mortgage backed securities, things ended badly.