The perils of the twenty-first century stock market
The markets face new risks with high frequency trading, says this British advisory, which has one antidote and some intriguing stocks.
Even the most sophisticated traders are throwing up their hands.
Stock markets have never been models of calm and rational deportment. They are more often cited as examples of crowd psychology run amok.
But they may be more irrational than ever.
In fact, our technological mastery, which might have been expected to make the markets more efficient, may be making them crazier.
Over the past month or so we have seen “the ugly side of greed and fear,” says one British commentator. We are also seeing the dangers of a new phenomenon — high frequency trading, or HFT.
Mr. Theo Casey tells the story in the latest edition of The Fleet Street Letter, which has been studying the markets for over 70 years.
Mr. Casey has developed a rather unusual way to counter the excess volatility of the markets.
But first we take a quick look into this British advisory’s portfolio, where we find several fascinating stories.
Still a buy
As this edition of the advisory went to press (about two weeks ago), BP plc (NYSE-BP) was still listed as a buy, despite the Gulf oil spill. It is not alone — one U.S. advisory published last week called the selling “overdone.” Still, BP has fallen to $33.97 in New York and the fall has pushed its yield up to almost 10 per cent on the $3.36 dividend.
The Fleet Street Letter also considers Russian natural gas behemoth Gazprom (LSE-OGZD) the “cheapest blue chip stock” on the market. Since we last checked in with them in March, it has gotten even cheaper, trading at $20.12 as opposed to $21.89. Nonetheless, this giant holds the key to Europe’s natural gas supplies.
The advisory also likes Mr. Warren Buffett’s holding company, Berkshire Hathaway (NYSE-BRK.B). This portfolio has the “B” shares on hold. They are trading today at $74.72.
It also believes that at least five per cent of every portfolio should be in hard gold, or gold stocks for the more adventurous.
Kicked out of trades
One of Mr. Casey’s colleagues has a great investment idea. But he keeps running into a brick wall.
He’s been shorting the euro against the dollar — but he is getting “stopped out.” Mr. Casey explains that “sensible risk management techniques are actually impeding my colleague’s currency trading. By placing stop-loss orders in sensible places, he was being kicked out of trades, paying the spread every time.”
That is, he loses on the bid-ask spread, paying the higher ask price each time (although bid-ask spreads in currency are usually fairly low).
For answers, Mr. Casey turns to an interview given to Bloomberg News by Mr. Joe Saluzzi, a partner at Themis Trading in New York and a market maker. Mr. Saluzzi doesn’t like the way equity trading is set up these days.
“He believes it has been corrupted by high-frequency trading — a form of investment that could produce many more examples of the downdraft we saw Thursday, 6 May, the date of the ‘flash crash’.”
HFT relies on quantitative algorithms and speedy access to markets. “These are traders that really have no particular interest in which direction the market is going, rather the speed with which they can trade,” says Mr. Casey.
These are also traders “with no obligation to make a market,” he adds. “And when they choose not to buy, the consequences are disastrous.”
This can lead to Mr. Saluzzi’s “worst fear” — margin calls, massive de-leveraging and everyone selling at the same time as the buyers disappear. “The problems are inherent in the structure,” he told Bloomberg, “and it will happen again.”
Buying on spikes
There’s another problem, says Mr. Casey. When the market rises, “individual companies may or may not rise in sympathy.”
But when the market falls, “most companies tend to join in regardless of whether or not their underlying businesses are affected by the symptoms. The markets, just like we all do in everyday life, tend to take bad news more seriously than good news.”
But why just get stopped out, he reasoned. During the period of the market’s greatest volatility in May, Mr. Casey noted that a number of audacious traders had made big profits.
They had done so with buy-limit orders. You enter these orders to buy a stock when it hits a certain price. Usually, these are placed lower than the current price, so you can “buy on the dips.”
But Mr. Casey saw an advantage in buying on price spikes. He sat down to follow a hedge fund that was showing a high degree of volatility and saw one quick rise that would have netted 7.5 per cent in 7.5 seconds. So he submitted an order above the current price in order to play for another spike.
“The type of spike that will transfer shares away from risk-conscious investors that are being stopped out and over to us, to make a quick gain.”
The quick profits were there, but this does not make Mr. Casey especially happy. They simply mean that the market is out of whack. “Bottom-up” fundamental data is secondary today to the “top-down bearish narrative” in the markets.
And high frequency traders are taking advantage of it. In short, says this observer, the mechanics of the equity market are suspect and the economics are even worse.
Most of us will not have the time or the inclination to play a high-speed game with buy limits and lightning quick changes in price. But many traders are doing just that, with no regard to the fundamentals we have been taught to prize so highly.
So all of us — even the most determined buy-and-hold investors — must be prepared for the shocks that high frequency trading can bring to the markets in the twenty-first century.
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