Is the "Deck" Really Stacked Against the Individual Investor?

A savvy client called me today and asked what I thought about an article that appeared in Barron's last weekend.

In the lead column written by Barron's Alan Abelson (in the August 28, 2010, issue), he mentioned a piece that had been sent to him from a magazine called International Economy.

Abelson wrote that he had never heard of the publication, and neither have I. Still, he spent part of his weekly musings talking about the article called "The Marginalizing of the Individual Investor", and concluded that the authors raised some pretty legitimate points.

http://online.barrons.com/article/SB50001424052970204885704575447721568324514.html#articleTabs_panel_article%3D2

Basically the authors (named Harold Malmgren and Mark Stys) believe that the ordinary investor is being systematically pushed out of the stock market due to the rapid growth in high frequency trading (HFT).

According to the authors, not only do HFT dominate trading, and so order flow, but the ability to capitalize on pricing anomalies in a nanosecond overwhelm the value of fundamental analysis, and make momentum trading the only way to successfully navigate the markets:

For decades, professional investment advisers have continued to teach reliance on “value investing” and “buy-andhold” as long-term guides to successful investment. Chief economists and market prognosticators for financial institutions also continue to urge us to keep focused on “market fundamentals” rather than sell when jostled by disruptive events, expecting “efficient markets” to generate a “fair price” in the whirlwind of market trading. Technology may now have overridden such investment concepts. High-frequency trading platforms are focused solely on ramping up speed and volume so as to maximize tiny gains per transaction. Computerized algorithms that are momentum-sensitive are increasingly high-frequency trading- driven, raising serious doubts about traditional concepts of how markets should work. Investment strategies based on fundamentals such as a company’s long-term performance have been swept aside by high-frequency trading algorithms hunting for inefficiencies in daily pricing and super arbitrage opportunities. In so doing, they open investors to a new form of risk that has not been accounted for in most “buy and hold” asset allocation models.

http://www.international-economy.com/TIE_Su10_MalmgrenStys.pdf

I can see why the authors came to the conclusions they did. As I wrote last week, the data from Ned Davis research indicates that the degree of correlation between stock price movements across all different sectors and industries is currently near an all-time record high - almost 0.80.

Moreover, there is no denying the popularity of exchange-traded funds (ETFs), which make it easier for investors to buy, sell and even short large groups of stocks in a fairly easy fashion. There are now nearly $1 trillion of ETFs outstanding currently.

Finally, market data would also suggest that large program trades being executed by either hedge funds or proprietary trading desks on Wall Street are often as much as 40% of the daily trading volume on the major stock exchanges.

So, my client asked, are we going to start managing money any differently?

My answer at this point is: Not yet.

The dean of security analysis (and mentor of Warren Buffett) was Benjamin Graham. Graham once said that while the stock market is a voting machine in the short run, it is a weighing machine in the long run. That is, while short term stock price movements can often seem random, the longer term trend of market prices will be determined by fundamentals.

Buffett even described the stock market as manic depressive. Sometimes it seems that everything is for sale, and the market despairs that nothing will ever go well again. Other times the market only wants to go higher, as investors are filled with confidence that the world has been forever changed for the better.

The corollary to this is Buffett's dictum that one should be greedy when all are fearful, and fearful when all are greedy. This is why Buffett was a big buyer of stocks in the Panic of the fall of 2008.

It seems to me, then, that today's HFT truly make short-term market timing impossible. Stock prices could vary widely based on programs that are little known to anyone outside the select few that are "in the know".

However, just because prices may more randomly today than they have in the past, I think that Graham's view still is intact - namely, the longer term "weight" of fundamentals will eventually determine stock price trends.

But I think the whole issue of HFT may something to follow closely, especially for regulators.