Wednesday, August 24, 2011

High Frequency Trading: Tail That Wags The Dog

From this Bespoke Investment Group post:

'All or Nothing' Days on the Rise

Whenever the market has a day where the net advance/decline (A/D) reading of the S&P 500 is greater than 400 or less then negative 400, we call it an 'all or nothing' day. 

The chart in the Bespoke Investment Group post says it all.

Check it out.

The chart shows that if you add up all the 'all or nothing' days that occurred in the entire 1990s decade, the total comes to 27.

That is nearly half than the amount we are now getting in a typical year. An objective look at what has changed to figure out what is causing something to behave so much differently is a good place to start.

From this CNBC article:

High frequency trading is a "major, major negative for the stock market" and the overall economy, legendary value investor Marvin Schwartz, managing director and senior portfolio manager at Neuberger Berman, told CNBC Thursday.

"These high frequency traders begin the day owning nothing and they end the day owning nothing in terms of common stocks. But during the day they're accounting for between 50 percent and 65 percent of the volume," said Schwartz.

"The liquidity that is added to the market is "useless," with "no lasting value," he added.

Well, it turns out the first big jump in annual number of 'all or nothing' days occurred four years ago. That, of course, may be just a coincidence.

Maybe.

Still, even if that is just a coincidence, it'd be wise to take a close look at each of the many market 'innovations' that have come about under the guise of liquidity and other specious justifications in recent years. This needs a dispassionate, unbiased look by someone with the right expertise.

High speed trading and other similar innovations may serve the participants involved just fine but market instability can do real damage to real economy.

If this turns out to be a case of self-inflicted instability via these so-called innovations, the regulators who ought to be policing these things need to alter how the game is being played.
(Something self-inflicted should be easier to fix than something caused by an external force.)

My gut is that at least some of the changes (created under what seems a fairly hollow pretense) may partly be contributing to the above Bespoke Investment Group chart.

Innovation in finance is more often than not just a clever new way to enhance the amount of leverage, speculation, and gambling within the system. This may benefit some market participants (civilization not so much) up to the point that the system becomes unstable.

If these frequently self-serving so-called enhancements go unchecked we all pay. From John Kenneth Galbraith's book, A Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

The reality is that the role of capital markets is far too vital to ever allow them to become a casino in disguise.

Global capital markets are now excessively large and complex. Whether they are actually performing their primary useful functions effectively often seems an afterthought.

It should be smaller, simpler, and more focused.

Charlie Munger doesn't see much benefit to the massive amount of trading between computers that goes on. He also doesn't seem to think the energy expended and talent utilized writing algorithms (that ultimately the rest of us pay for) provides much social contribution.

"...why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? No I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance?" - Charlie Munger

Munger: Cut Banking Sector 80%

We need less energy put into leveraged speculation and gambling with more time spent helping capital get to a good idea.

It's a monster of our own making. All too frequently, the tail that's wagging the dog to a greater than necessary extent.

Some may be okay with that but the markets serve us, not vice versa, and those with oversight responsibility need to make adjustments when, for whatever reason, they are functioning this far below potential.

Adam

Related post: 
High Speed Trading: Tail That Wags The Dog, Part II (follow-up)

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