The stock market keeps rising, setting new records just about every week. The S&P 500 has risen over 15% since Election Day 2016, and shows no signs of slowing down. That's an annualized rate of over 20% a year, which is exceptionally good for an aged bull market as we have.
The election of Donald Trump as President was seen as a major reason for the rally. He promised infrastructure spending, tax reform and other measures that should stimulate the economy. But his Presidency has sunk into a quagmire of chaos, incoherence and unpredictability. These, coupled with the legal risks emanating from special counsel Robert Mueller's investigation, should have triggered market retrenchment. But stocks have hardly blinked before levitating some more. Whatever is driving the market, it doesn't have much to do with the Trump Presidency.
Accommodative monetary policy in Europe and Japan is also said to be a reason for the market's buoyancy. Foreign central banks have been printing money, and some of it supposedly has found its way into the U.S. markets. But the dollar has been falling recently, indicating liquidity is flowing out of our markets, not in. That's not a formula for a rally.
Corporate earnings, although pretty decent, aren't dramatically better than last fall. They don't explain the lighter-than-air quality of stocks today.
So what's going on? Let's consider that over half of all stock market transactions consist of computerized trading. Machines are trading with machines, using algorithms known to very few. These algorithms verge on alchemy. They rely on statistical correlations that may or may not hold true in the future. These correlations can be disrupted by unexpected government policy, political upheaval or conflict, economic change (such as the effective collapse of OPEC as a functional cartel), and technological change (such as the fracking that just blew up OPEC). They also utilize artificial intelligence, seeking to learn from their ongoing experiences in the market and modifying their algorithms as a result of what they learn. Thus, the humans may have difficulty anticipating what the programs will do tomorrow. And the programs may produce a positive or negative synergy or other interaction that humans have not foreseen.
Computerized trading is opaque. That is, in real time, no one knows for sure if a trade or a series of trades involved a machine or two machines or none. One should avoid anthropomorphism in today's stock markets. In other words, one should not ascribe human motives, intentions or characteristics to market activity. There may be no reason comprehensible to humans for today's stock prices. When computers use artificial intelligence to trade stocks, the valuation of financial assets may be fundamentally changed, and changed beyond human comprehension. You may think that stock prices are whacked out--and you could be correct from the human perspective.
Homilies like stocks are excellent long term investments and will protect against inflation were derived at a time when people dominated the financial markets and established the asset valuations on which these notions were based. If machines that function opaquely suddenly become dominant, how can humans understand the valuations determined by the machines? More succinctly, how can you tell what's a good price and what's a bad price anymore?
There are many more questions than answers in a machine-dominated market. When the market keeps setting new record highs in machine-dominated trading, be careful. We are bravely, or not, going where no investors have gone before. And no one really knows what's going to happen.
Showing posts with label computerized stock trading. Show all posts
Showing posts with label computerized stock trading. Show all posts
Monday, July 31, 2017
Wednesday, February 22, 2017
Investing in a Time of Trump
If there's one notable feature of investing in the nascent Trump Presidency, it's uncertainty. Although macroeconomic statistics are generally good, we are startled every day by a spinning kaleidoscope of tweets, leaks, executive orders, allegations, innuendoes, news stories, fake news stories and occasional court rulings that splatter across our field of vision and further contort the cognitive dissonance in the political scene from the recent election. When all news and news-substitutes seem to be open to challenge, what can an investor rely on?
The ever-rising market only makes things worse. With such political confusion, it's far from clear that the economic and tax policies espoused by President Trump will be implemented any time soon. Why does the market persistently climb higher? One can only suspect that some market participants have conflated optimism with delusion. The background music to today's market may not be the Grand March from Aida (https://www.youtube.com/watch?v=TX0qN6QEvGg), but rather Jimi Hendrix's Purple Haze (https://www.youtube.com/watch?v=cJunCsrhJjg).
What can an investor make of all this? Bear in mind that you can't see a lot of what's going on in the market. There are major undercurrents, often computer driven, that cause daily market schizophrenia. Large investors can push the market one way or another in the course of making large purchases or unwinding large holdings. Mom and Pop investors won't see this or hear about, except maybe after the fact.
Computerized trading can be particularly scary. It no longer consists of following pre-determined algorithms. Much of today's computerized trading is dynamic, using artificial intelligence-type programs that try to figure out as the trading day progresses where prices are headed and buy or sell to take advantage of the anticipated market move. Since much of the trading these programs are observing is done by other computers, we have computers reacting to other computers. Price, which traditionally has been a judgment call made by intuitive and irrational humans, is now the product of chains of logic. That logic tends to respond to short term stimuli, such as price movements in the last few minutes, seconds and even milliseconds. It doesn't factor in the uncertainty in Washington.
People know the future is cloudy. But the computers don't. Computers don't feel fear, nor do they have to save for retirement or build up a cash reserve to guard against a layoff or a large unexpected expense. People may hold onto their cash, wondering if the market is too bubbling given the chaos in the White House. But a computer may boldly keep buying, egged on by the trades of the past 20 milliseconds.
If you're hesitant about the market, keep your powder dry and your cash in an FDIC guaranteed bank account. There's no computer program that can understand and explain Donald Trump. Today's stock market may be too heavily driven by short term inputs, without a full understanding of longer term risks. Remember the old computer adage: garbage in, garbage out. If today's computerized trading is pushing the market up based on an incomplete picture, prices will eventually rise too far, if they haven't already. Then, le deluge.
The ever-rising market only makes things worse. With such political confusion, it's far from clear that the economic and tax policies espoused by President Trump will be implemented any time soon. Why does the market persistently climb higher? One can only suspect that some market participants have conflated optimism with delusion. The background music to today's market may not be the Grand March from Aida (https://www.youtube.com/watch?v=TX0qN6QEvGg), but rather Jimi Hendrix's Purple Haze (https://www.youtube.com/watch?v=cJunCsrhJjg).
What can an investor make of all this? Bear in mind that you can't see a lot of what's going on in the market. There are major undercurrents, often computer driven, that cause daily market schizophrenia. Large investors can push the market one way or another in the course of making large purchases or unwinding large holdings. Mom and Pop investors won't see this or hear about, except maybe after the fact.
Computerized trading can be particularly scary. It no longer consists of following pre-determined algorithms. Much of today's computerized trading is dynamic, using artificial intelligence-type programs that try to figure out as the trading day progresses where prices are headed and buy or sell to take advantage of the anticipated market move. Since much of the trading these programs are observing is done by other computers, we have computers reacting to other computers. Price, which traditionally has been a judgment call made by intuitive and irrational humans, is now the product of chains of logic. That logic tends to respond to short term stimuli, such as price movements in the last few minutes, seconds and even milliseconds. It doesn't factor in the uncertainty in Washington.
People know the future is cloudy. But the computers don't. Computers don't feel fear, nor do they have to save for retirement or build up a cash reserve to guard against a layoff or a large unexpected expense. People may hold onto their cash, wondering if the market is too bubbling given the chaos in the White House. But a computer may boldly keep buying, egged on by the trades of the past 20 milliseconds.
If you're hesitant about the market, keep your powder dry and your cash in an FDIC guaranteed bank account. There's no computer program that can understand and explain Donald Trump. Today's stock market may be too heavily driven by short term inputs, without a full understanding of longer term risks. Remember the old computer adage: garbage in, garbage out. If today's computerized trading is pushing the market up based on an incomplete picture, prices will eventually rise too far, if they haven't already. Then, le deluge.
Thursday, January 15, 2015
Artificial Intelligence in the Stock Markets
Artificial intelligence has been much in the news recently. Well-recognized deep thinkers have propounded profound thoughts that predict good and bad outcomes for artificial intelligence as it becomes ever more of a reality. The takeover of the world by machines is inevitable--with monstrous consequences--or not, depending on who you ask.
There isn't much real-world empirical data relevant to the opposing sides of this argument. But one big clinical trial is underway: in the stock markets. Most of the trading done today in the stock markets consists of computerized trading. Institutional investors, like mutual funds, pension funds, and so on, comprise most of the rest. Mom and Pop, trying to invest a few nickels for their retirement, are like pedestrians surrounded by massive semis barreling along at interstate speeds.
Much of the computerized trading is done by dynamic computer programs. In other words, the computer doesn't buy and sell based on a static algorithm embodied in the program coding. The program can change itself in response to market conditions and activities. In essence, depending on what the program detects is happening in the market, it can alter its own coding without the need for a human programmer to keypunch and proofread line after tedious line of code. The details of how these dynamic programs work are generally shrouded in commercial secrecy. But we have a situation where computer programs take note of what's going on in their working environments, think about how to change themselves to be more effective (i.e., profitable) in light of changing conditions, and then alter themselves to do better. That's getting rather close to what people do: try to change and improve themselves in order to advance their careers or make more money in their professional activities.
We have seen in recent years how computerized trading can cause mini-crashes and other short term turbulence in the stock markets. Mom and Pop are often finding the waters too rough, and suddenly see the virtue in the paltry returns of passbook savings accounts or certificates of deposit whose yields have been flattened by the nearly supine yield curve. Even some professional money managers are looking for ways to fly over or around the storm clouds of computerized trading, moving trading to venues that claim to allow only "natural" (non-computerized) investors to participate.
For academic researchers and other prognosticators, the dynamic computerized trading in the stock markets could furnish a useful body of data with which to work. The rest of us, unwilling guinea pigs in a clinical trial we didn't sign up for, can only look to financial regulators and other government officials to ensure that the results of the experiment don't turn out too badly,
There isn't much real-world empirical data relevant to the opposing sides of this argument. But one big clinical trial is underway: in the stock markets. Most of the trading done today in the stock markets consists of computerized trading. Institutional investors, like mutual funds, pension funds, and so on, comprise most of the rest. Mom and Pop, trying to invest a few nickels for their retirement, are like pedestrians surrounded by massive semis barreling along at interstate speeds.
Much of the computerized trading is done by dynamic computer programs. In other words, the computer doesn't buy and sell based on a static algorithm embodied in the program coding. The program can change itself in response to market conditions and activities. In essence, depending on what the program detects is happening in the market, it can alter its own coding without the need for a human programmer to keypunch and proofread line after tedious line of code. The details of how these dynamic programs work are generally shrouded in commercial secrecy. But we have a situation where computer programs take note of what's going on in their working environments, think about how to change themselves to be more effective (i.e., profitable) in light of changing conditions, and then alter themselves to do better. That's getting rather close to what people do: try to change and improve themselves in order to advance their careers or make more money in their professional activities.
We have seen in recent years how computerized trading can cause mini-crashes and other short term turbulence in the stock markets. Mom and Pop are often finding the waters too rough, and suddenly see the virtue in the paltry returns of passbook savings accounts or certificates of deposit whose yields have been flattened by the nearly supine yield curve. Even some professional money managers are looking for ways to fly over or around the storm clouds of computerized trading, moving trading to venues that claim to allow only "natural" (non-computerized) investors to participate.
For academic researchers and other prognosticators, the dynamic computerized trading in the stock markets could furnish a useful body of data with which to work. The rest of us, unwilling guinea pigs in a clinical trial we didn't sign up for, can only look to financial regulators and other government officials to ensure that the results of the experiment don't turn out too badly,
Monday, October 21, 2013
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.
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.
Thursday, August 2, 2012
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.
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.
Sunday, March 25, 2012
The BATS IPO and the Stupidity of Computers
BATS's aborted IPO on Friday, March 23, 2012, is an excellent example of the stupid side of computerized trading. While the precise course of events isn't entirely clear, BATS (short for Better Alternative Trading System) tried to initiate trading in its own stock around 10:45 a.m., at a price of $15.25 per share, or $0.75 per share below the IPO price of $16. Not a good sign when an IPO begins trading below the offering price. But that wasn't the really bad news. Rather, trading in BATS stock stopped moments later for technical reasons.
Around 10:48 a.m., BATS announced it was looking into "system issues" concerning stocks having symbols between A and BFZZZ. Nine minutes later (10:57 a.m.) Apple stock, which was trading in the high 590's, suddenly traded on BATS at $542.80 a share for a single 100 share transaction. This was a 9% drop from the previous price, even though there was no intervening news or other public event. Trading in Apple stock was halted. Five minutes later, it resumed back in the high 590's.
Around 11:07 a.m., BATS informed other exchanges that it was having problems and they need not send orders to it. Since competition for order flow is the essential dynamic between exchanges, this instruction was like making an unexpected pit stop in a NASCAR race.
At 11:14 a.m., BATS resumed trading in its own stock with a large trade at $15.25 per share. Within seconds, BATS shares were trading for pennies per share. Trading in BATS stock was halted again, and didn't resume. Near the end of the day, BATS announced that it was withdrawing its IPO.
In essence, we had flash crashes in Apple (which rebounded within minutes) and BATS (which cratered in the most embarrassing way on its IPO day). These morasses were apparently the result of computer glitches. Both were plain stupid, perfect examples of stupid is as stupid does. It's inconceivable that a human trader would have sold 100 shares of Apple at $542 on no news when the market was in the high 590's. There's no way a human trader would have sold BATS stock for pennies seconds after BATS traded at $15.25. That these trades happened is because a computer has no way to tell when it's doing something stupid. It can only follow the instructions in its program coding. And if the coding is deficient, the computer will blithely plunge forward however stupid the result.
Of course, human traders are eminently capable of stupidity, and are stupid more often than not. But humans trade much slower than computers. And few humans control as much order flow as computers at the large high-speed trading firms. So when a computer does something stupid, it can do it really fast and perhaps in really large quantities. No human is fast enough to stop the computerized stupidity before it happens. And no computer has been programmed to have the judgment and common sense to realize that it's about to do something really stupid.
Friday's morass didn't affect the larger market, which ended the day up. But it serves as a reminder that the baseline problem in computerized trading--how to prevent it from having unexpected and undesired consequences--is hardly any closer to solution than before the Flash Crash on May 6, 2010. Unless high speed trading firms can find a way to prevent stupid trades, their animal spirits will likely be curbed. And it's hard to argue against constraining them when they produce results as ridiculous as last Friday's.
Around 10:48 a.m., BATS announced it was looking into "system issues" concerning stocks having symbols between A and BFZZZ. Nine minutes later (10:57 a.m.) Apple stock, which was trading in the high 590's, suddenly traded on BATS at $542.80 a share for a single 100 share transaction. This was a 9% drop from the previous price, even though there was no intervening news or other public event. Trading in Apple stock was halted. Five minutes later, it resumed back in the high 590's.
Around 11:07 a.m., BATS informed other exchanges that it was having problems and they need not send orders to it. Since competition for order flow is the essential dynamic between exchanges, this instruction was like making an unexpected pit stop in a NASCAR race.
At 11:14 a.m., BATS resumed trading in its own stock with a large trade at $15.25 per share. Within seconds, BATS shares were trading for pennies per share. Trading in BATS stock was halted again, and didn't resume. Near the end of the day, BATS announced that it was withdrawing its IPO.
In essence, we had flash crashes in Apple (which rebounded within minutes) and BATS (which cratered in the most embarrassing way on its IPO day). These morasses were apparently the result of computer glitches. Both were plain stupid, perfect examples of stupid is as stupid does. It's inconceivable that a human trader would have sold 100 shares of Apple at $542 on no news when the market was in the high 590's. There's no way a human trader would have sold BATS stock for pennies seconds after BATS traded at $15.25. That these trades happened is because a computer has no way to tell when it's doing something stupid. It can only follow the instructions in its program coding. And if the coding is deficient, the computer will blithely plunge forward however stupid the result.
Of course, human traders are eminently capable of stupidity, and are stupid more often than not. But humans trade much slower than computers. And few humans control as much order flow as computers at the large high-speed trading firms. So when a computer does something stupid, it can do it really fast and perhaps in really large quantities. No human is fast enough to stop the computerized stupidity before it happens. And no computer has been programmed to have the judgment and common sense to realize that it's about to do something really stupid.
Friday's morass didn't affect the larger market, which ended the day up. But it serves as a reminder that the baseline problem in computerized trading--how to prevent it from having unexpected and undesired consequences--is hardly any closer to solution than before the Flash Crash on May 6, 2010. Unless high speed trading firms can find a way to prevent stupid trades, their animal spirits will likely be curbed. And it's hard to argue against constraining them when they produce results as ridiculous as last Friday's.
Wednesday, February 29, 2012
Maybe the Retail Investor is Retiring
A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.
But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.
The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.
But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.
The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.
Monday, August 29, 2011
Stock Market Regresses
The stock market is behaving increasingly like a petulant teenager. It's moody, impulsive, flighty, delirious one moment, and despondent the next. Since the financial crisis of 2008, individual investors have fled while professional traders increasingly dominate. Today, computerized trading is a larger part of the market than trading by sentient human beings. Computerized trading to a large degree involves following trends (the stock market term is "momentum trading"). Does that remind you of high school?
Investing on fundamentals seems to be done more outside the market than in it. Look Warren Buffet's big deals--in negotiated transactions, he bought a railroad, and special preferred stock from Goldman Sachs and Bank of America. He doesn't bet big money (that is, big money for him) trading stocks.
The stock market has become a playground for professional traders, who use it for short term speculation. In that way, it has regressed back to the 19th Century. When the robber barons held sway, savers didn't put their money into common stocks. They made deposits in bank accounts and bought bonds. Common stock was viewed as a vehicle for gambling. The few stocks that savers might buy were those with a solid history of paying dividends, and perhaps preferred stock, which had rights to dividends superior to common stock but no voting rights. Either way, a stock's ability to deliver cash in the form of dividends was crucial to its attractiveness to savers.
The state of affairs today is comparable, with so much cash flowing into banks that at least one is charging large depositors for the privilege of making deposits. The U.S. Treasury market is rallying from the flow of funds out of stocks and into safe havens, in spite of S&P's downgrade. There remains some investor interest in stocks that are proven dividend payers. Otherwise, the thrill of capital appreciation is increasingly left to the Wall Streeters who let their computers do the trading.
The Federal Reserve's relentless campaign to crush all interest rates attempts to coerce savers to put their money into riskier assets, in the belief that if savers lose their life savings to market volatility, the economy will somehow recover. But the Fed seems to be missing a basic point about investing. It's done when savers have confidence in the investment. When savers think the putative investment is a tractor trailer laden with bullswaggle, they won't send in a buy order. Making savers feel poorer by taking away their only safe sources of interest income will make them more insecure, spend less and swear off stocks. People who can stash some of their savings in secure, income generating vehicles are more likely to risk other savings in stocks. People who are repeatedly frustrated in their quest for a port in today's financial storms won't unfurl the sails and hope that the gale will somehow propel them to calmer waters.
The Fed seeks a wealth effect by using lower interest rates to support and bolster stock prices. The problem is that lower interest rates make savers feel less wealthy, especially retirees who count on their savings. Has the Fed netted out the discouragement to savers it imposes against the encouragement it gives to stockholders? Since many people are both savers and stockholders, they'll net out the impact, understanding that you can never recoup interest that didn't accrue during a time of low rates, but that stock gains may be ephemeral. Then they'll boost spending--or not.
With the advent of derivatives, computerized trading and no end of structured financial products that are too complex for battered investors to truly understand, it's easy to overlook the regressing of the financial markets. But with that in mind, is it any wonder individual stock market investors are becoming an endangered species?
Investing on fundamentals seems to be done more outside the market than in it. Look Warren Buffet's big deals--in negotiated transactions, he bought a railroad, and special preferred stock from Goldman Sachs and Bank of America. He doesn't bet big money (that is, big money for him) trading stocks.
The stock market has become a playground for professional traders, who use it for short term speculation. In that way, it has regressed back to the 19th Century. When the robber barons held sway, savers didn't put their money into common stocks. They made deposits in bank accounts and bought bonds. Common stock was viewed as a vehicle for gambling. The few stocks that savers might buy were those with a solid history of paying dividends, and perhaps preferred stock, which had rights to dividends superior to common stock but no voting rights. Either way, a stock's ability to deliver cash in the form of dividends was crucial to its attractiveness to savers.
The state of affairs today is comparable, with so much cash flowing into banks that at least one is charging large depositors for the privilege of making deposits. The U.S. Treasury market is rallying from the flow of funds out of stocks and into safe havens, in spite of S&P's downgrade. There remains some investor interest in stocks that are proven dividend payers. Otherwise, the thrill of capital appreciation is increasingly left to the Wall Streeters who let their computers do the trading.
The Federal Reserve's relentless campaign to crush all interest rates attempts to coerce savers to put their money into riskier assets, in the belief that if savers lose their life savings to market volatility, the economy will somehow recover. But the Fed seems to be missing a basic point about investing. It's done when savers have confidence in the investment. When savers think the putative investment is a tractor trailer laden with bullswaggle, they won't send in a buy order. Making savers feel poorer by taking away their only safe sources of interest income will make them more insecure, spend less and swear off stocks. People who can stash some of their savings in secure, income generating vehicles are more likely to risk other savings in stocks. People who are repeatedly frustrated in their quest for a port in today's financial storms won't unfurl the sails and hope that the gale will somehow propel them to calmer waters.
The Fed seeks a wealth effect by using lower interest rates to support and bolster stock prices. The problem is that lower interest rates make savers feel less wealthy, especially retirees who count on their savings. Has the Fed netted out the discouragement to savers it imposes against the encouragement it gives to stockholders? Since many people are both savers and stockholders, they'll net out the impact, understanding that you can never recoup interest that didn't accrue during a time of low rates, but that stock gains may be ephemeral. Then they'll boost spending--or not.
With the advent of derivatives, computerized trading and no end of structured financial products that are too complex for battered investors to truly understand, it's easy to overlook the regressing of the financial markets. But with that in mind, is it any wonder individual stock market investors are becoming an endangered species?
Wednesday, February 9, 2011
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.
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.
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