Archive for August, 2011

The High Price of High-Frequency Trading

Thursday, August 18th, 2011

Whatever its perceived benefits, HFT is changing the way the stock market operates.

It used to be that companies went public to raise capital; investors took risks by buying company stock, and the company and investors were rewarded when the company used its capital wisely.  The principles of supply and demand dictated stock prices, creating an efficient market in which prices adjusted based on market demand.

But HFT is affecting market fundamentals.

The majority of trades taking place today are driven not by company performance, but by tiny inefficiencies that only computers can detect.  While investors are advised to “buy and hold” their investments for years, computers are trading in nanoseconds.  High-frequency traders also buy and sell options, futures, exchange-traded funds (ETFs), currencies and all other financial instruments that are traded electronically, so its impact goes beyond the stock market.

Individual investors used to be the heart and soul of the stock market.  Today, big hedge funds and big banks are making billions of dollars off of HFT based on information that is unavailable to the average investor.  Just as small investors were hurt by the 1987 crash, while program trading gave big traders an advantage, technology again is creating an unfair advantage for big investors.

Since its introduction in 1999, electronic trading has transformed the way stock markets operate.  Other electronic trading strategies are also having an impact on the market, although not to the degree that HFT is.

We need to keep in mind, though, that computers are only as good as the information that goes into them.  Comparisons can be made to the mortgage industry.  While there were many other issues involved, the recent financial crisis began after computers took over the processing of mortgages and many unqualified people became homeowners.

Likewise, when computers do the trading on the stock market, removing the human element, mistakes are likely to happen.  The more dominant HFT becomes, the bigger the next accident is likely to be.

For more information, see my article on high-frequency trading here.

High-Frequency Trading Accounts For Three Out of Four Trades

Wednesday, August 17th, 2011

With graphs of stock market prices looking like the Alps recently, people are hearing a great deal about high-frequency trading (HFT) and its impact on the market.

Except for hearing media comments about it after last May’s “flash crash,” though, most investors know little about it.  So what is it and why should you care?

HFT, which is conducted by proprietary trading desks at big banks and private hedge funds, uses computers to make trading decisions and execute trades based on perceived pricing inefficiencies.

It now accounts for 73% of all equity trading in the U.S., up from 30% four years ago, according to TABB Group, which researches financial markets.  It
is not as dominant in other countries, but its use is growing.

Not only has HFT grown in volume, it has grown in speed.  While computers took a couple of seconds to execute trades a few years ago, today trades are being executed in nanoseconds – that’s billionths of seconds.

The greater the use of HFT, of course, the greater the impact it can have.  And, because programs in place today trade so rapidly, HFT can wreak havoc on the market.

During the “flash crash,” the Dow Jones Industrial Average fell nearly 1,000 points in 20 minutes – the fastest and largest drop in market history.

Individual investors have been leaving the market as HFT has grown.  As HFT continues to fill the void, it may continue to push out the individual investor
and take on an even greater percentage of trading volume.

Some support the use of HFT, suggesting that it lowers volatility, narrows the spreads between bid and offer prices, creates liquidity and reduces the cost of trading for all market participants.

If HFT lowers volatility, shouldn’t the market be less volatile than it used to be?  HFT may also increase liquidity, but that liquidity is not available when it is needed most.

200-Day Moving Average Says the Bear Is Back

Wednesday, August 10th, 2011

Investment managers regard the 200-day moving average price of an index such as the S&P 500 or of an individual stock as the dividing line.  An index or stock trading above the 200-day average is being bought and is in an upward trend.  An index or stock trading below the 200-day average is being sold and is in a downward trend.

The moving average smoothes out short-term price fluctuations and provides a high-level look that makes sense of the market.  For money managers attuned to managing risk, a close below the 200-day moving average marks a change in trend, from a bull market to a bear market.

The market moved prices below the 200-day moving average on Tuesday, Aug. 2, indicating the start of a bear market.

In response, we recommend that portfolios remain diversified, with higher-than-normal money market balances, fixed-income holdings and low-correlated assets.  This will protect investors from experiencing the full brunt of the stock market sell-off.   While buying opportunities are likely to present themselves, they should be considered cautiously and with discipline.

The U.S. Isn’t Greece – Yet

Tuesday, August 9th, 2011

If a “sovereign debt” crisis in Greece (population 10.7 million) can cause stock prices around the world to fall, what will happen to world markets if there is a similar crisis in the United States (population 307 million)?

The questions is relevant, given Standard & Poor’s decision to lower the U.S. credit rating from the perfect AAA it has held since 1917 to AA+. While some of the recent stock market drop – the worst since 2008 – can be attributed to other factors, such as sovereign debt in Europe and the continuing weak economy, the lower credit rating, has had a significant market impact.

The U.S. isn’t Greece – at least not yet – but it seems to be heading in that direction, in spite of the recent debt ceiling agreement, which cut $2.5 trillion from future spending.

Greece’s debt represents 155% of gross domestic product and is expected to reach 170% next year, according to The Wall Street Journal. In other words, the government is spending $1.55 for every dollar’s worth of goods the country produces.

Meanwhile, the U.S. debt-to-GDP ratio is approaching 100% – even though it excludes an estimated $61.6 trillion in unfunded obligations for Medicare, Medicaid and Social Security. In addition, state and local governments have trillions of dollars in unfunded debt obligations.

In addition to running a $1.5 trillion budget deficit, the U.S. government added $5.3 trillion in financial obligations in 2010 for off-budget items, according to USA Today.

Maybe we’re not so far away from Greece after all.

Market Going In Wrong Direction

Monday, August 8th, 2011

With profits exceeding analyst forecasts and a debt-ceiling agreement reached, there was reason to believe that the market might be ready to reverse direction and head back up last week.

Given the expectation of continued strong profits, it looked like the S&P 500 could reach the 1,400 to 1,425 level by year end (it’s high so far this year was 1,370).  Now though, the chances for that level of price appreciation are increasingly appearing remote.

Consider why:

  • Credit rating downgrade.  The U.S. government had maintained a perfect AAA credit rating since 1917 until Standard & Poor’s downgraded it to AA+ on Friday.
  • Sovereign-debt crises. Europe’s troubles have spread far beyond Greece.  Ireland, Spain, Portugal and now Italy are all financially unfit.
  • High unemployment. Unemployment remains above 9%, in spite of the $814 billion economic stimulus program, extension of the Bush-era tax cuts and two rounds of quantitative easing.
  • Low economic growth.  Earlier in the year, many were concerned that gross domestic product grew at an annual rate of just 1.9%.  It turns out that figure was too generous.  The Bureau of Economic Analysis revised the first quarter growth rate down to 0.4%, while the economy grew at an annual rate of just 1.3% in the second quarter.
  • The debt crisis.  While last week’s agreement reduced future spending by an estimated $2.5 trillion (assuming the projected cuts all take place), keep in mind that the agreement allowed government to add $2.5 trillion in new debt, which would raise the ceiling to $16.8 trillion.  It also leaves Medicare, Medicaid and Social Security untouched – even though they represent $61.6 trillion in unmet obligations.

Suddenly, the 1990s seem like a lifetime ago.