September 26, 2012
Some people have lost their taste for the stock market, with many concluding it's more dangerous than they can tolerate for their kids' college money or retirement savings.
And they have reason to be anxious.
At a Senate banking committee hearing in Washington last week, professionals who have been involved with the high-frequency trading that dominates stock buying and selling confirmed some of the worst fears of individuals struggling with investments: The stock market has been behaving erratically and playing with people's emotions as frenetic stock movements have often been divorced from either the economy or businesses' performance.
It no longer is your parents' or grandparents' stock market. Rather, it's become a Wild West of trading, with errant technology too often in control and setting stocks, commodities, currencies and futures up for violent moves that could make the $1 trillion flash crash of May 2010 look tame by comparison, testified David Lauer, who has designed trading technology and worked as an analyst for Allston Trading and Citadel Investment Group.
"U.S. equity markets are in dire straits," Lauer said. "We are truly in a crisis."
He noted that "retail investors have been fleeing the stock market in droves" and that the Chicago Booth/Kellogg School Financial Trust Index shows "investor confidence is nonexistent — with only 15 percent of the public expressing trust in the stock market."
Rather than buying a stock and holding onto it, institutions using high-frequency trading buy and sell stocks constantly in milliseconds, or much faster than a blink of the eye. Lauer said about 50 to 70 percent of the volume of trading in the stock market now takes that form. Often trading systems send out phony trades aimed at manipulating others into buying or selling. The activity can mislead legitimate traders working for mutual funds, pension funds or individuals to buy a stock at too high a price or sell it at too low a price.
It might involve pennies. But when combined day in and day out "it's death by a thousand cuts," said Andy Brooks, vice president and head of U.S. equity trading for one of the nation's largest mutual fund companies, T. Rowe Price. And computer glitches involving everything from Facebook's initial public offering to the flash crash of 2010 have left individuals with the lowest confidence he says he's ever seen.
"As we talk with our clients there is a growing distrust of the casino environment," Brooks testified at a committee hearing convened by Sens. Jack Reed and Mike Crapo. "Speed kills. We don't think it's for the benefit of investors."
Lauer added: "We must be concerned with whether the pendulum has swung too far." He wants the Securities and Exchange Commission to know who is trading, although much of it is now secret. And he wants more regulation because he fears a catastrophic flash crash late in the day could set off a panic that could cause stocks and other securities to plunge worldwide.
Although high-frequency traders insist that they help the markets by buying stocks during stressful periods, Lauer said that during the 20-minute flash crash, traders refused to buy a thing. They allowed stocks to plunge because "none of us knew what to do or what would happen next."
"That dramatically worsened an unstable situation," he said. "Something is dreadfully wrong."
Individuals sense the problem as they see stocks rising or plunging for seemingly no reason.
In a sign of the angst, individuals have refused to buy stocks despite the Standard and Poor's 500 index climbing almost 15 percent this year and 27 percent over the last 52 months. As stocks climbed, individuals pulled their money out of stock funds for 35 of 37 weeks, said Charles Biderman, chief executive of TrimTabs Investment Research. "They abhor stocks, particularly U.S. stocks."
As individuals leave the market and it becomes the domain of institutions, the markets become increasingly fragile and volatile.
"Complexity has become the hallmark of the new electronic landscape," said Lauer. He and others credit technology with reducing the costs individuals and institutions incur when they buy and sell stocks, but his concern is that complex systems "can also spin out of control in unexpected ways."
Lauer notes that "mini flash crashes" happen on a "near-daily basis." Even without a "catastrophic event" he said society is paying a price. As retail investors leave the market and companies are leery of selling stock publicly, he notes "IPOs have dramatically dropped."
When young companies cannot raise the capital through an IPO, they cannot grow as well as they might, and hiring is stunted.
As pressure builds for more regulation, insiders from trading firms pummeled NYSE Euronext Chief Operating Officer Larry Leibowitz at a Securities Traders Association conference in Washington last week to start a media campaign to rebuild confidence in the markets.
But Leibowitz said he thinks the public reaction is transitory; a result of the fragility that's leftover from declining home values, job losses and stock market losses in the 2008-09 financial crisis.
CME Executive Chairman Terrence Duffy told an audience on financial markets at Georgetown University's McDonough School of Business last week that Congress, industry regulators, industry groups and the CME need "to restore confidence in all aspects of the financial marketplace."
But he warned that regulators had to be careful about "impeding sound financial market development."
Reed, speaking to the same audience that Leibowitz addressed, warned traders that Capitol Hill can't take as long as it usually does to consider regulation of high-frequency traders because of the speed that new technologies are bringing to the market. He said he is concerned that a trading mishap could pose risks to the system.