Monday, January 10, 2011

Stock Market Morphs into Casino

As background, here's a quick summary of something that was covered in this previous post:

The average holding period for stocks was between 4 and 8 years from the early 1930s until the late 1970s.

In the 1980s it dropped to more like 2 years.

At the time of that previous post last March, the average holding period for stocks had fallen to more like 6 months and James Montier had the following to say about it:

"...the average holding period for a stock listed on its exchange is just 6 months. This seems like the investment equivalent of attention deficit hyperactivity disorder." - James Montier

Fast forward to today. According to this recent CNBC article, the average holding period has now dropped to 2.8 months (in the 1980s it was more like 2 years) with high frequency trading accounting for 70 percent of market volume.

"The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

Then later in the article...

"The capital raising stock market of the past hundred years has morphed in just the last 10 years into a casino," said Sal Arnuk of Themis Trading and a market infrastructure expert who advised the SEC after last year's so-called Flash Crash. "Who is doing the fundamental work analyzing stocks? In the end, we've greatly increased systemic risk."

The frictional costs and mostly (if not entirely) non-productive activity associated with all this hyperactive trading makes capital raising and allocation systemically less effective.  It's a hidden "tax" on the capital raising/allocation system and ignores Newton's 4th Law ("for investors as a whole, returns decrease as motion increases").

John Bogle recently said that the SPDR S&P 500 ETF (SPY) turns over at 10,000% annualized rate. At that rate, the gap between the returns investors as a whole actually achieve and what the fund returns could easily approach 5% per year due to frictional costs. In the interview, John Bogle references a study of 175 ETFs that showed it was more like a 6% gap per year for investors. In other words, the typical investor would fall behind by 30% over a five year period. I'm guessing most of the active traders involved think they will be above average and end up on the winning side:

"All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers' costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers' take, which median result may well be somewhere between unexciting and lousy." - Charlie Munger Speech to the Foundation Financial Officers Group

In this case, the total croupiers' cost is the 5-6% of frictional expenses noted above. The fact is all this extra activity means by definition that investors as a whole end up with a 5-6% lower per annum return. Pretty expensive when the 8-10% expected long-term annual market returns are far from a certainty. So in this example the system as we know it today is transferring half or more of returns to the croupiers instead of investors. Jeremy Grantham made the point that fees like this actually "raid the balance sheet".

Yet, keep in mind it is only those participants who decide to play the trading game that have to collectively pay this "tax".  An investor who either buys and holds long-term something like the SPY or buys great businesses at fair prices and holds those shares a very long time avoids these frictional costs.

Check out the full CNBC article.


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