The Griswolds are not the only ones to be in misery, investors this holiday season are also feeling miserable.  The back half of the year has seen a dramatic rise in volatility that has shaken investor confidence in the market itself.  Markets have routinely seen wild swings in the futures market prior to the open in New York, before the European close, and in the last hour of trading in the US.  This pattern has been an almost daily occurrence and at times seems to have no connection to actual fundamental information.  The mystery of this market behavior leaves investors wishing cousin Eddie emptying his chemical toilet was the biggest source of irritation this Christmas.

In “The Calm Within The Chaos” (March 2011) we explained how liquidity did not equate to stability but rather the structure of many different time horizons was the source of stability.  This structure itself has been under assault as correlations and price dislocations reached extreme levels.  These extreme conditions correlate to a rise of high frequency traders (HFT) who often account for most of the volume on a given day.  HFT are becoming leading providers of liquidity, but that is illusory to an extent.  Most HFT orders are now cancelled almost instantly.  The liquidity provided is of fleeting quality as it is only available for such a fraction of time (often less than a second).  This means the absolute shortest time horizon has now become bloated relative to other time horizons.  So despite apparent liquidity the market structure is now out of balance and less stable.  The lack of stability has significantly exaggerated daily market moves and left investors feeling like they have received a membership into the jelly club of the month club as a bonus.    

“WORSE?  How could things get any worse?  Take a look around…We’re on the threshold of hell” ¹

Some of the institutions that investors assume will be guardians and at least try to make it a fair game are really not. The exchanges themselves have become the dealer for HFT.  Exchanges are now for profit institutions.  Many are now publicly traded and under the same pressures to produce quarterly earnings as the rest of the companies listed on the exchanges.  It has been estimated that up to 80% of the exchanges’ revenue is currently being driven by HFT activity.  So the exchanges have more incentive to cater to HFT needs and not to being an impartial referee assuring fairness.  While trading costs have indeed declined so has the level of transparency.  The opacity has intentionally been created in order to generate revenue.  This is done via cancellation fees, creation of various proprietary conditional order types, leasing space, access order flow, a lack of a consolidated audit trail, etc…  It’s not illegal as the exchanges have created a less transparent system that for them is now more profitable.  To be as damaging as HFT have become, they need speed and a lack of clarity, and the exchanges have been very willing dealers of both.  This now leaves investors at a precarious threshold.

What make this threshold dangerous are the cascading effects HFT can trigger.  Simply put too many models are trading on the same information.  By trading on pricing patterns too many models at once can implement the same trade and trigger wild movements that are totally unrelated to fundamentals.  Fair value should get restored but the violent nature of the move itself can cause investors to question their own information and lose confidence. Therefore, the restoration process is not usually as quick as the original price dislocation occurred.

“Can I refill your eggnog for you? Get you something to eat?  Drive you out to middle of nowhere and leave you for dead?” ¹

Predatory trading has always existed in some form but now even professional buy-side traders are reaching for the eggnog with a little extra kick.  One of the best buy-side traders recently told us the lack of control over order routing, transparency, and speed has him feeling defensive.  Rather than adding value through trading his job has now become more focused at preserving value and limiting the number of trades that may fall victim to HFT.  If HFT has a professional feeling vulnerable and left for dead, what can an individual do?

Investors can start by defining their investment strategies.  The shorter the time horizon the more vulnerable an investor is to the influences of HFT.  Investors need to define the horizon of each investment.  A more cyclical shorter term strategy may need to be more actively traded to deal with the negative influences.  Longer term investments or ones not contained in major indices such as Africa or focused targeted small cap infrastructure are more likely ones investors should leave be and allow their longer horizon to restore value.  If the strategy is clearly defined in advance it allows investors to more clearly distinguish how to react and when to be patient.

“I simply solved the problem.  We needed a coffin..er, a tree.” ¹     

 

Trading is currently occurring about as fast and orderly as Clark Griswold Jr.’s saucer sled.  Slowing down the market can only occur via regulation at the exchange level.  Regulators around the globe are beginning to formulate assorted solutions how to do so.  The buy side community needs to become vocal in SEC comment periods.  In the end financial incentives for transparency need to be created.  Making the minimum price increment larger (say from 1/100^th of a penny to half a penny) and more meaningful may be a start and provide more incentive for transparency.  Mandating orders be posted for longer time periods, addressing conditional orders and cancellation rates that have gone wild is also needed.  These issues are now beginning to get the attention they deserve.  It does seem that some measures to begin the process are on the way.  In the longer term fundamentals still will dictate value.  In the meantime we all may be best served by taking a tip from Clark Griswold Sr. on how he got through the holidays: “I had a lot help from Jack Daniels.”

 

 

As always, we are pleased to be your partner in fighting the misery, and proud to be a leader in Intellectual Exploration and Stewardship Without Compromise. 

 

 

1 National Lampoon’s Christmas Vacation. Dir. Jeremiah S. Chechik. Warner Bros. Pictures, 1989.

 

 

 

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www.galwayinvestmentstrategy.com