October 7, 2010
Individual investors went AWOL from the market in droves in the past quarter as evidenced by the remarkable 23% shrinkage in third-quarter trading volume from the corresponding year-earlier quarter.
The deep wounds in the average investor portfolio is a painful reminder of the ferocious bear market that bit so deeply into nest eggs. The more recent flash crash (May 6th) only served to strengthen the not entirely unreasonable conviction that the market is rigged against them.
I don’t know whether or not you saw the “news at 11:00”, but I have been officially labeled a dinosaur. Yes, the market has passed me by, and my relevance/passion/expertise is considered (sigh) passé. Why, you ask, do I feel old and in the way? The answer is – HIGH FREQUENCY TRADING (HFT) and ELECTRONICALLY TRADED FUNDS (ETF).
Most investors are no longer bothering to pore through corporate reports (lazy) searching for gems or duds, instead trading large buckets to gain a few dollars on a trade. My long-term beliefs of value investing is not working very well these days. (How’s that for coming clean?)
I am not surprised. Years ago, I told those who would listen that ETFs would kill us. I never believed, though, that searching for undervalued companies would take a back seat to computer algorithms for determining a company’s value and/or fate. As a result, investors are confronted with overwhelming momentum-driven forces unrelated to corporate performance. A “fair price” may exist, but high-frequency traders are not seeking fair prices—they are focused solely on immediate profit.
The “experts” are saying that it is an indexing market and not a market for stocks. They say that macro forces have overwhelmed the ability to pick stocks. On good days everything goes up, and on bad days everything goes down. It is harder for individual investors and even for money managers to distinguish themselves by doing individual stock picks. They might get the product right and the earnings right, but the market goes down and the stock is going to go down as well. Many stock picking professionals with whom I’ve spoken stated that their approach feels like an exercise in futility. Five, ten years ago I could dig around and tell you the reason why, for instance, TSYS either went up or down. Today, that is simply not possible most of the time.
The market’s flock-like behavior is one more reflection of the growing influence of investors using broad-based strategies to buy and sell large blocks of stocks. Instead of picking individual stocks to hold over a period of time, they trade in and out of the market using broad indexes. Often, these investors use exchange-traded funds, which trade as easily as a single stock but contain many different stocks that may belong to the S&P 500, the NASDAQ 100 or another index. Heavy trading in exchange-traded funds means more stocks are likely to move in the same direction on any given day. Analysts call that correlation, a mathematical term meaning similarity of behavior. Correlation is on the rise, which is frustrating to me because I analyze stocks based on their underlying strengths and weaknesses. ( A dinosaur I tell you, a dinosaur…)
There’s a growth market in……… pessimism!
High-frequency trading (HFT), is focused solely on ramping up speed and volume to maximize tiny gains. This implies that “investment strategies based on fundamentals have been swept aside by high-frequency algorithms hunting for inefficiencies in daily prices and super arbitrage opportunities.” And since high-frequency traders have become the dominant market makers and shakers, their capacity to turn on a dime and sell off everything, means that a market correction could go fast and deep.
A stock is worth its future earnings, but that involves uncertainty. The more uncertainty there is, the lower the P/E will be. Therefore the P/E ratio tends to fall as uncertainty rises, and vice versa. There have been periods when the P/E ratio was much more in vogue. A century ago, the buying and selling of stocks was widely considered to be a form of gambling. P/E ratios came about as a way to quantify the true value of a company’s shares. The creation of the Securities and Exchange Commission during the 1930s made financial information more available to investors, and P/E ratios gained widespread acceptance in the decades that followed.
But thanks to the recent shift toward rapid-fire stock trading, the P/E ratio is losing its relevance. The emergence of exchange-traded funds in the past 10 years has allowed investors to make broad bets on entire baskets of stocks. And the ascendance of computer-driven trading is making macroeconomic data and trading patterns more important drivers of market action than fundamental analysis of individual companies, even during periods of relative calm.
In summary, macro forces do drive today’s markets and HFT & ETFs are overwhelming the de facto market makers. (Can you say flash crash?) But I do believe we can still pick stocks at reasonable values and make money. My towel remains out of the ring with no intentions of tossing it in.
In ways large and small, the 2008 financial rescue, which officially expired on Monday, altered not just Wall Street but also the political, economic and social landscape. Lawmakers who voted for TARP are fighting for their political lives. Bailout anger has all but ruled out the chance of federal intervention in the foreseeable future. The Federal Reserve has seen its independence threatened. And the Obama administration’s ability to respond to the economic crisis has been constrained. This whole event will have political implications for 30 years.
SO HERE WE ARE IN THE HOME STRETCH of this anything but dull year, and the inevitable question intrudes: What now, for the Dow, S&P, NASDAQ and the marvelous multiplicity of other investment indices? Unfortunately, my crystal ball is in the shop for repairs (You always knew the thing wasn’t working anyhow), so for peering into the future – we’ll just have to wing it
A month from now the citizenry of this grand country—or at least those diligent souls who can bestir themselves to participate in a midterm election—will go to the polls and pull the lever or touch the screen. The results, save for the unlikely failure of the Republicans to take the House as widely predicted, would likely not affect the markets beyond a momentary blip or dip.
You probably know that I have often professed to a contrarian style of investing. In the real world, a contrarian stance is rarely totally amiss when it runs counter to expert opinion, especially when the experts are self-anointed and pretty much of one mind. In the stock market, especially in this one, which can and does change in a flash, the crowd may not always be wrong, but for investors to rush to embrace the prevailing sentiment can prove the equivalent of taking a stroll in Kabul without body armor.
An anonymous sage once remarked that an expert is just “an ordinary man, away from home, giving advice”.
Best wishes for a comfortable autumn and a sane, agreeable congress!
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