Henry Frankenstein: Look! It's moving. It's alive. It's alive... It's alive, it's moving, it's alive, it's alive, it's alive, it's alive, IT'S ALIVE!
Victor Moritz: Henry - In the name of God!
Henry Frankenstein: Oh, in the name of God! Now I know what it feels like to be God!
Victor Moritz: Henry - In the name of God!
Henry Frankenstein: Oh, in the name of God! Now I know what it feels like to be God!
Enjoy one of the great rock instrumentals of all time...Edgar Winter Group - Frankenstein
There has been a lot of talk lately about High Frequency Trading (HFT), and its impact on the volatility of the markets. While I'm no expert on the subject, I have been investing/trading for nearly 30 years so I thought I would share my observations.
First HFT does not analyze company fundamentals, they analyze data patterns. The goal is to extrapolate what they are seeing in one set of data to other markets before the crowd gets there. They hire the brightest mathematical brains to develop algorithms that identify these patterns. Speed is a key weapon. Many HFT shops locate their servers close to the exchange where they trade to cut down on the time it takes to execute a trade. The average holding period is between 10 milliseconds and 10 seconds. By some estimates HFT accounts for anywhere from 40% to 70% of average daily volume, and even more on extremely volatile days. (The following link gives a good wonkish explanation of HFT High-frequency trading )
While its hard to dispute the fact that HFT increases liquidity, it's a different kind of liquidity, a fake liquidity that generally moves all in one direction. Also, when the computers step away volume can dry up in a flash, hence the term "Flash Crash".
One of the more interesting outcomes of HFT and it's increased liquidity is that it hasn't increased market efficiency. What has happened instead is that stocks are more correlated than ever before. Some of this increased correlation is a result of exchange traded funds, and leveraged exchange traded funds, which buy and sell baskets of stocks in particular sectors. This has caused individual stocks valuations (P/E ratios, P/S ratios, etc) to converge, regardless of their fundamentals. How else do you explain a company with the growth prospects of Apple trading at 11 times earnings (9 times ex-cash)?
Many market players have simply reverted to asset allocation and sector allocation, and have given up on picking individual names. This is what I do through my Global Tactical Asset Allocation model, I'm not trying to fight the markets/machines, I'm just trying to participate on the upside, and protect on the downside. But this increased inefficiency also creates opportunities for individual stock picking. If every stock in a sector is going down in unison regardless of their fundamentals, then the best stocks in that sector may become very attractive. I say "may" because they all might move back up in unison. In my personal trading account I have been able to take advantage of some of these short-term pricing inefficiencies, but I emphasize the word short-term.
Investing has changed, as everything has changed. Some for the good, some for the bad. Only time will tell if HFT does more harm than good. We as investors have to learn to adjust and adapt.
One of the things that endears us to Dr. Frankenstein is his willingness to push the envelope...
Henry Frankenstein: Dangerous? Poor old Waldman. Have you never wanted to do anything that was dangerous? Where should we be if no one tried to find out what lies beyond? Have your never wanted to look beyond the clouds and the stars, or to know what causes the trees to bud? And what changes the darkness into light? But if you talk like that, people call you crazy. Well, if I could discover just one of these things, what eternity is, for example, I wouldn't care if they did think I was crazy.
What makes mankind great is our desire to learn, to push boundaries, and to grow. This is the dominate theme of all of human history. Of course, this pushing of the envelop is not without risk, especially in finance. We all remember the "financial innovation" that gave us, portfolio insurance, credit default swaps, and securitized bundles of mortgages. These inventions were extremely profitable, for a while. But costs and unintended consequences were ignored along the way, and eventually we paid a very dear price.
It is important that we ask tough questions of our innovators, but equally important that we don't stifle that innovation. Maybe that's why we sympathize with Dr. Frankenstein, we know that we'll be repeating his mistakes for hundreds of years.
We don't know if HFT is good or bad, time will tell. As investors we have to find a way to adapt to our current environment, and hopefully prosper.