Tuesday, August 23, 2011

Time for a Transaction Tax?

By some estimates, as much as 70% of the recent volume on the New York Stock Exchange has been computer-driven trading.

These are orders being placed not based on any economic or company specific reason. Instead, they are largely based on complex mathematical algorithms developed by funds hoping to exploit tiny changes in stock prices for quick profits.

These formulas may focus on order flow (i.e. high frequency trading) or momentum (e.g. "buy 'em when they're going up" or "sell 'em when they're heading south"). While perfectly legal, computer-driven trading mocks those who try to figure out why stocks move in any direction on a given day.

Today's market swings makes it very difficult for investors who base their decisions on fundamental analysis. It also makes market movements much more volatile, since the computer-driven trading can place huge buy and sell orders in a fraction of a second.

Ned Davis Research put out a report at the end of last week noting that the dominance of computer-driven trading has lead to an extremely high level of stock price correlations - in fact, the highest since 1987.

According to Ned Davis, the median 63-day correlation of stock price movements in the S&P 500 reached 0.84 as of August 17, 2011, as compared to the average of 0.45 over the last 40 years. Put another way, successful investing in recent weeks has been entirely based on momentum investing, and almost nothing on fundamentals.

This morning's New York Times carried an interesting idea: a sales tax on Wall Street. Every trade would carry a tiny sales tax which would both raise revenue as well as discourage hyperactive trading that creates such volatility.

As author Nancy Folbre, a professor at University of Massachusetts explains:

Most of us pay state and local sales taxes on most things we buy, and most casino gambling is subject to state taxes ranging from up to 6.75 percent in Nevada to 55 percent on slot machines in Pennsylvania.

But speculative purchases of stocks, bonds and other financial instruments in the United States go untaxed but for a tiny fee (less than a half-cent) on stock trades that helps finance the Securities and Exchange Commission.

In Britain, by contrast, a 0.5 percent tax on stock transactions raises about $40 billion a year. President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany recently announced plans to introduce a similar tax in the 27 nations of the European Community.

It is variously called a “transactions tax,” a “financial transactions tax,” a “security transaction excise tax” or a Tobin tax (after the Nobel Prize-winning economist James Tobin, who famously argued for its application to foreign exchange purchases in the late 1970s).


Wall Street, of course, hates the idea of a transaction tax, but perhaps its an idea whose time has come.