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Avoiding The Stock Market

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May 18, 2010

In the wake of the stock market’s “flash crash” on May 6, there have been an increasing number of reports that retail investors (“Ma and Pa”) are pulling their money out of stocks.  Beyond that, some commentators have stepped forward to speak out and advise retail investors to steer clear of the stock market, due to the volatility caused by “high-frequency trading” or HFT.  One recent example of this was Felix Salmon’s video message, which appeared at The Huffington Post.

HFT involves a practice wherein firms are paid a small “rebate” (approximately one-half cent per trade) by the exchanges themselves when the firms buy and sell stocks.  The purpose of paying firms to make such trades (often selling a stock for the same price they paid for it) is to provide liquidity for the markets.  As a result, retail investors would not have to worry about getting stuck in a “roach motel” – not being able to get out once they got in – after buying a stock.  Many firms involved in high-frequency trading (Goldman Sachs, RGM Advisors, Tradebot Systems and others) have their computer servers “co-located” in the same building as the exchange, in order to get each of their orders processed a few nanoseconds faster than orders coming from further distances (albeit at the speed of light).  The Zero Hedge website has been critical of HFT for quite a while.  They recently published this informative piece on the subject, pointing out how HFT firms caused the catastrophe on May 6:

. . .  when the selling in size commences they all just shut down.  So much for providing liquidity when it is needed.

At The Market Ticker website, Karl Denninger explained how HFT platforms often use “predatory algorithms” to drive a stock’s price up to the full extent of a customer’s limit order (a practice called “frontrunning”):

Let’s say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40.  That is, the buyer will accept any price up to $26.40.

But the market at this particular moment in time is at $26.10, or thirty cents lower.

So the computers, having detected via their “flash orders” (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) “immediate or cancel” orders – IOCs – to sell at $26.20.  If that order is “eaten” the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40.  When it tries $26.45 it gets no bite and the order is immediately canceled.

Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become “more efficient.”

Nonsense; there was no “real seller” at any of these prices!  This pattern of offering was intended to do one and only one thing – manipulate the market by discovering what is supposed to be a hidden piece of information – the other side’s limit price!

The extent to which frontrunning takes place was the subject of a recent conversation between Larry Tabb of Tabb Group and Erin Burnett on CNBC.  The Zero Hedge website provided this analysis of the video clip:

The funniest bit of the exchange occurs at 3:35 into the clip, when Tabb publicly discloses that front-running is not only legal but occurs all the time on open exchanges. When Erin Burnett, who unfortunately still thinks that the Deutsche Mark is used in Germany, asks who is doing the front running, Tabb says “It could be anyone.”

A recent piece by Josh Lipton at the Minyanville website focused on the activity of retail investors since the recent “flash crash”:

Specifically, during the past week through May 12, your friends and neighbors pulled $2.8 billion out of US stock funds, according to the latest data from the professional number crunchers at Lipper FMI.

To put that stat in context, we called up Robert Adler, the head of Lipper FMI Americas, for a chat this morning.  He tells us that’s the most investors have pulled out, in fact, since March 11, 2009.

At the same time, says Adler, investors plowed $16.6 billion into money-market funds.  “That’s the first inflows money market funds have seen in the last 16 weeks,” he says.

*   *   *

“There was an about-face this past week by investors,” Adler says, noting that such outflows from both equity and bond funds, and a sharp reversal in money market funds, demonstrate a clear and dramatic shift in sentiment.

The analyst is quick to emphasize, however, that one week doesn’t make a trend.  “We have to wait another week to see whether this was simply event driven or if this is the beginning of a new trend,” he says.

The current risk-aversion experienced by retail investors is compounded by the ugly truth that stocks are currently overvalued.  Shawn Tully of Fortune made this very clear in a May 17 commentary, wherein he provided us with a sage bit of prognostication:

Here’s how I see the odds.  The chances are about one in three that we suffer a huge, wrenching correction in the next year or two similar to the one in 1987.  That possibility is so high because stocks are so startlingly expensive.  Another high probability event is that markets go on a long sideways grind, with smaller drops along the way.  What’s extremely unlikely is that the market rises substantially from current levels and stays there for any extended period.

Whatever happens in the next couple of years, the odds are overwhelming that investors who buy stocks today will reap puny returns for 10 years.  For example, if you’d purchased shares at today’s PE of 22 in early 2003, you would have gotten a return of around 3% a year, barely enough to compensate for inflation, let alone buy the blood pressure medication you’d need to survive the scary ride of stock ownership.

Now let’s look out a decade or two.  The evidence is extremely strong that price matters, and matters a lot:  except in rare cases, buying stocks when they are pricey — when the Shiller PE exceeds 20 — leads to puny returns ten years later.

Not that you’d ever know that from the happy talk from Wall Street.  So screen the noise out, and follow the numbers.  They’ll eventually get better for investors.  But to get back there, we may revisit October of 1987.

Considering the unlimited number of awful news events unfolding in America and around the world right now, we could be headed for a market crash much worse that that of October, 1987.  Cheers!