Monday, August 20, 2012

“Point of No Return”

Sydney M. Williams

Thought of the Day
“Point of No Return”
August 20, 2012

The stock market was once seen as a barometer for the economy. It tended to be reasonably predictive in its behavior of future economic behavior. (I say “reasonably” because, as Paul Samuelson once said, “The market has predicted nine of the last five recessions.”) It was never foolproof – nothing could ever be that easy – but it reflected the dreams and hopes of millions of small investors, and the considered expectations of thousands of professional portfolio managers.

Its original purpose was to raise capital for fledging businesses and to allow more mature ones to raise funds. For investors, it provided a means of valuing one’s portfolio and the liquidity to buy and sell. In time, it proved a means by which millions of small investors could accumulate savings for retirement. The New York Stock Exchange was also, however, a club that provided a venue for members to accumulate wealth – though certainly not with the rapidity of today’s hedge fund managers, or corporate beneficiaries of option grants.

The forty-five years that my yoke has been hitched to the stock market have seen a lot of changes. Individuals who once dominated have been replaced by institutions. Commissions, which were once fixed, became “negotiated” (though in name only, as institutions now dictate terms.) Volume has increased by a magnitude of a factor of almost 1000. Tickertapes, which once ran along the front of every brokerage firm’s front room, have been replaced by Bloomberg, Reuters and Thompson screens. Paper tapes are unknown by the vast majority of Wall Street participants. Information, which once seeped slowly out, is now available instantly, twenty-four hours a day, seven days a week.

As damaging, in my opinion, is the news last Friday that Jon Corzine will face no charges, despite the apparent validity to the accusation that his firm did comingle customer funds with those of his firm. While he disclaims any responsibility, had events turned out otherwise there is little question in my mind that his hockey stick would have poked new holes in the sky. The whole episode does little to restore confidence in a system that most people see for the cronyism that it is. Having friends in high places means something, whether the symbol of your party is an elephant or a jackass. While cronyism impairs confidence, it is not new.

In my opinion, the single biggest change has been the commoditization of the market. Investing in individual companies and holding those investments for months, if not years, was the preferred venue for investors. Today, individual securities are packaged in myriad instruments from indexes to derivatives to ETFs. They all serve useful purposes, but collectively they have altered the landscape beyond recognition for many traditional investors. Computers have made the trading of these instruments (and individual stocks) capable of being bought and sold at lightening speed, creating havoc when something goes awry, as it did on October 19, 1987 when “portfolio insurance”, designed to protect investors against loss, instead created its own self-fulfilling cascade of falling prices. The “Flash Crash” on May 6, 2010 and the Knight Securities loss of $440 million in a few minutes are more recent examples.

It is not as though markets did not crash in earlier days. They did. We have all heard of October 28th and 29th, 1929 when the Dow Jones lost 20% over two days, and 40% over the next several weeks. By June of 1932, the market was down almost 90% from the highs it had reached in August 1929. In 1974, the markets lost about 40% of their value from their highs to their lows in December of that year. Panic knows no venues, and neither does greed. But today we are not only susceptible to age-old patterns of behavior, but to glitches in technology that have nothing to do with fear and greed.

Last Monday, the New York Times ran a front page article on the rising costs of high speed trading. High frequency traders, in my opinion, essentially serve their own purpose – making money. Thus far, regulators have left them alone, believing them when they claim to have brought liquidity to markets. They speak of the sharp increase in shares traded daily and of the enhanced competition between exchanges. They cite the declining spreads between bid and ask prices, and the fact they have helped reduce the time it takes to execute a trade from 3.2 seconds to 48 milliseconds, an astounding 98.5% improvement. They have helped reduce the average commission paid on a per share basis. But it is hard to argue that they in any way have helped fundamental investors. In helping to turn an exchange on which were traded pieces of paper representing ownership in businesses to trading spreads based on some esoteric algorithmic formula has done little to differentiate between companies performing poorly and those doing well. Each of these computerized trades, for the most part, are done for a relatively small number of shares (a few thousand shares at a time and having nothing to do with underlying fundamentals of the companies involved), while institutional investors’ ownership of companies are generally represented by millions of shares. A doubling or tripling of volume based on algorithmic formulas does little to provide real investor liquidity. It is unclear to me that two computers or more, trading a thousand shares at a time, but doing millions of trades in a day, has done much for liquidity. There is also, in my opinion, the very real risk of a firm front-running customer orders. Chinese walls on Wall Street are usually made with rice paper.

The article in the Times shills for these trading firms when they write that “the total cost for an investor to get into and out of a single share of stock fell by more than half between 2000 and 2010, to 3.5 cents per share. They fail to note that the individual investor has largely forsaken the stock market giving their money to mutual funds whose fees have remained as high as ever; so it’s hard to understand exactly how the individual investor has benefitted. Certainly, ten years of generally flat markets have not tempted the investor back into the waters made muddy by increasingly complex strategies and derivative instruments.

Over the years, John Bogle has demonstrated the great advantage of index funds for those small investors who have neither the inclination nor the capabilities of picking a portfolio of stocks. The advantage of index funds is both in their low costs and broad diversification. Studies have also shown that the majority of actively managed funds, after fees, underperform the indices. Like ETFs, index funds, definitionally, make no distinction between well managed and poorly managed companies.

Adding to the uncertainty was the failure of Dodd-Frank to not only fail to address the problem of “banks too big to fail”, but, in fact, to make those banks bigger. In his book Bailout, Neil Barofsky notes that since early 2008 assets at JP Morgan Chase have grown by 36%, those at Wells Fargo have more than doubled, while Bank of America’s assets have increased by 32%. Not only are banks bigger today, they are more politically influential than ever. Breaking them up (my preference) may prove impractical. Simple rules demanding higher capital ratios as assets expand would alleviate – though not eliminate – the risk of failure. The bigger one’s balance sheet, the less leverage one should be able to deploy. And, when determining capital ratios, all off balance sheet items should be considered.

All of the above: High frequency trading that benefits a small number of people at the expense of the majority; the consequences of algorithmic, quantitative trading schemes that cause markets to be vulnerable to flash crashes, and the fact that risk to the financial system is bigger than ever, have added uncertainty to a market that has produced subpar returns for a dozen years. It is little wonder that people view markets as casinos, not barometers of economic activity. On the positive side, on the other hand, many of these strategies may have inadvertently mispriced individual equities, providing opportunities for research-intensive investors.

In Point Of No Return, John P. Marquand’s 1929 novel, he wrote: “To him politics was like the weather. You could make occasional forecasts, but you could not control it.” Markets are different than they were forty-five years ago, though they are similar in that no one has ever been able to control them. Many of the changes have been positive. Technology has allowed markets to be more efficient and more available to increasing numbers of people. But technology has done little to improve transparency and has done even less to prevent criminal behavior. Additionally, myriad products have rendered our markets more commodity-like, allowing for more of a casino-like atmosphere, in which immediate self-gratification has replaced long term investing. Ultimately such changes are detrimental to our capitalist system, in that start-up businesses have found access to capital more elusive, and the confidence has been sapped from the millions who rely on investments for saving and retirement. However, nothing in life is constant. We must learn to adapt, accepting what’s best and rejecting what’s worst.

If Professor Samuelson was correct about the predictive qualities of past markets, today it is more likely that they will predict twenty of the next two recessions, or none of the next two – in other words, any predictive quality the market may have had has been neutered. One cannot help wondering whether, with high frequency trading models, commoditization and the crony capitalism manifested in the Washington-Wall Street revolving-door policies, we have reached our own point of no return. This is not to suggest markets cannot rally, but it may inhibit any near term return to the kind of bull market we had in the 1980s -1990s.

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