Exacerbation

Volatility

Stock markets have been volatile, plummeting on dismal economic signals, soaring on bargain hunting.  Yet, the wild gyrations seem to evidence overreaction. The US stock markets have been changing 1% to 5% more days than not, even though the news of the day may not be all that unexpected.

Force

Stock market volume is dominated by automated execution programs and algorithmic trading strategies through exchange traded funds (1), high frequency trading (2) and index investments popularized by the “efficient market theory” (3). These strategies can force buys or sells of individual securities, overwhelming fundamental buyers or sellers, and thus exacerbating market volatility. Auction markets fail when there is forced selling in excess of buyers coming to market or forced buying in excess of sellers coming to market. The U.S. Securities and Exchange Commission found that “lacking sufficient demand from fundamental buyers or cross-market arbitrageurs … the  interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets” (4). Traders can also exacerbate volatile markets (5).

Crash

Crashing markets cause damage: collateral for loans disappears and then banks can fail; companies can fail when they can’t get refinanced by the banks or the markets; investors can lose confidence and pull their money out, forcing prices even lower. The downward spiral can be devastating and persistent. As investors flee to safe assets, they can push the prices of those assets high, as they buy  for safety instead of for intrinsic value, recently pushing gold up 300%, treasury bills to negative yields, and certain currencies, collectibles, commodities and some real estate to fantastic levels. These formerly secure asset classes are themselves now subject to a crash at any time, as their high prices ultimately cause a reduction in demand while at the same time incentivizing new supplies to the market.

Distortion

Instead of maintaining orderly and rational markets, helping businesses grow, and building up confidence,  authorities are reacting by scare mongering to muster support for their agenda, artificially lowering interest rates which distort markets, and flushing money into an economy that is incapable of investing it.

Abuse

Exchanges, large banks, brokerages and  investment firms are profiting from the high volumes, commissions, trading opportunities and management fees from computer trading, derivatives and index funds.  Despite a history of market failures leading to economic catastrophes, no new regulations are in sight, such as implementation of the Volker Rule (6).  Stock markets always need both a bid and an offer from fundamental investors; if either one is missing, not only can they fail, but markets can be abused.

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(1)  As the name implies, exchange traded funds (“ETF’s”) are funds that can trade on exchanges. ETF’s hold specified investments, such as the securities that make up an index like the S&P 500. Trading their own capital, market makers are responsible for matching the supply of ETF’s to the demand, in ways that are usually very profitable. A Swiss bank recently reported a $2 billion loss and in 2008 a French bank lost $7 billion, both due to rogue traders in their ETF market making groups. The CEO’s of both banks had to resign, but there was never a thought of closing down the trading units, suggesting the profit was worth the risk.  When ETF’s are bought or sold, the underlying securities are subject to automated execution programs.

(2)  High frequency trading (“HFT”) is thought to account for over 70% of market volume. Run by computers, the orders are set to take the lowest offer or highest bid when there is an opportunity to make a gain of any size, constantly canceling and replacing orders as other buy and sell orders appear. The trading desks that run these systems are typically large brokerage firms or banks investing their own capital, just as they do with ETF trading. The HFT systems can trade the same financial instrument literally thousands of times a day and never keep the financial instrument overnight.

(3)  Efficient market theory (“EMT”) posits that all information on the markets is available rapidly to everyone and discounted immediately, leaving no opportunity for an informed investor to profit from knowledge or insight. EMT advocates prefer to invest in passive investment strategies, such as the S&P 500 index, and assume the underlying individual securities are properly priced by the market. When indexes are bought or sold, the underlying securities are subject to automated execution programs.

(4) In “Findings Regarding the Market Events of May 6, 2010” http://www.sec.gov/news/studies/2010/marketevents-report.pdf the CFTC and SEC
investigation found that the intraday stock market drop of 1000 points, now known as the “Flash Crash,” was due to one large S&P 500 related sell order wiping out every buy order while high frequency trading and exchange traded fund orders continued unabated, pushing the market down, with some stocks eventually trading for 1 cent before rebounding.

(5) In “Findings Regarding the Market Events of May 6, 2010”  market makers were blamed for not doing their job, effectively allowing the markets to crash. In 1938, Joseph P. Kennedy, Sr. implemented the uptick rule when he was SEC Chairman. He had observed short sellers profiting through market manipulation by massing  together stock sales in excess of market demand, contributing to the market  crashes leading into the Great Depression. The uptick rule restricted short  selling in a stock except if the stock had just had a trade at a higher price.  The rule was repealed in 2007.

(6)  Paul Volker, Jr., who knows the proclivities of banks only too well as the Chairman of the Federal Reserve under Presidents Carter and Reagan, proposed what became known as “The Volker Rule,” which would prohibit banks or related entities from engaging in proprietary trading (using their own capital to make investments), except as directed by clients. Initially receiving support from President Obama, the Volker Rule was never implemented.

About Nick Stonnington

Nick Stonnington has been a wealth advisor since 1983. He founded Stonnington Group in 2004 to better serve clients by offering them a platform for independent fiduciary advice. The Stonnington Group team manages client investments and advises on their businesses. Nick was ranked #1 in Los Angeles by Registered Rep Magazine in 2002 for "America's Best Wealth Advisors." Nick's expert commentary has been featured in such publications as the Wall Street Journal, Los Angeles Times, New York Times, Investment News, and Investment Advisor. His research has been published in the Family Wealth Report and he has written articles on investing for numerous industry journals.
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1 Response to Exacerbation

  1. Pingback: Intervention | Money Matters

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