Sean Park Portrait
Quote of The Day Title
Where information is effectively infinite, intelligent people will be involved in a Darwinian struggle to be heard above ... [hover]
- Michael H Goldhaber

Are (traditional) financial markets broken?

I don’t have much invested in traditional public equity markets, just a handful of relatively small positions in my (self-directed) pension fund. I haven’t done any robust analysis but my intuition tells me that my average holding period for these positions is probably around 2-3 years, with perhaps a bit of trading (lightening up or adding to existing positions) one or twice a year. And watching the markets from the sidelines over the past month or so certainly hasn’t made me regret this modest, passive allocation. When massive, mature companies trade up and down by 10 or 20% in a period of days – with no or little company specific news, confidence in the market’s ability to set prices in an orderly fashion clearly goes out the window. Indeed, the (public) equity markets are dangerously close to losing their ability to provide one of their key benefits: price discovery. And if/when this comes to pass, there will be serious knock-on effects on their other prime (and beneficial) function of capital allocation (and providing access to capital to companies and access to companies to investors.)

The risk is that a tipping point is reached at which the traditional public equity markets cease to be relevant venues for raising capital or investing. As many people have recently remarked (Kill the Quants Before They Kill Us, Beat high-frequency trading machines by not playing their game, etc.) possibly the key driver of this trend is the relentless increase in algorithmically-driven machine trading (high-frenquency or otherwise.) Now don’t get me wrong, I am neither a luddite, nor am I fundamentally opposed to these trading strategies; rather all other things being equal I would probably consider myself a proponent. In moderation, these types of trading strategies add both liquidity and heterogeneity to the market and as such help create a more robust trading ecosystem. But recently, the equilibrium of this system has come unstuck. Anecdotally, it is now assumed that upwards of 60% of trading volumes on the main public stock exchanges are accounted for by algorithmic/machine-directed trading. On some days and in some stocks, I understand that this can be as much as 80+%.

And most of these strategies don’t involve any judgement as to the valuation per se of a company; basically, as the Onion put it so brilliantly many years ago: they are just “trading” a “blue line”.

Blue Line Price History

NEW YORK–Excitement swept the financial world Monday, when a blue line jumped more than 11 percent, passing four black horizontal lines as it rose from 367.22 to 408.85.

So nobody is actually setting the price! (…or more accurately, the “price-setters” in the markets are mostly being overwhelmed by the trend-trading machines.) This does have the side effect of creating real trading and investment opportunities for on the one hand a small number of smart nimble day traders and on the other hand a small number of very long term investors (who have the luxury of having deep pockets and patience) but for the vast majority of investors (professional or private) the market dynamics and extreme short term volatility make participation more and more painful. This is particularly the case in a low-return environment such as today. Clearly execution (entry and exit points) have always been important, even to long term investors, but never have they been make or break like they have been in August: who cares if you have a carefully crafted investment thesis that predicts a 20-40% appreciation over 2-3 years in Company A when depending on the day of the week on which you entered the position, the thesis is rendered somewhat moot by a 20% swing in the share price.

And it’s no wonder that strong, growing private companies are often loathe to have their shares listed: what right-thinking CEO wants to deal with that insanity???

So what’s the solution? I don’t pretend to have an answer, but I do have a couple suggestions that perhaps point in the right direction for smarter people than I to develop into actionable plans:

  • design structural dampeners (through exchange rules and regulations) that limit the volume of algorithmic trading to some maximum proportion (to be A/B tested to find the optimal point – 40? 50? 60? percent?); this could also be a dynamic number, for example increasing or decreasing with intraday volatility to damp same
  • encourage the continued development of private secondary markets (SharesPost, SecondMarket and others) and help to develop them as real alternatives (and complements) to traditional public equity markets.

It’s really important that our global capital markets operate robustly and efficiently. In fact it’s never been more important. I believe that reasonable, robust solutions exist (or can be developed.) But I fear that the inertia and prejudices of entrenched incumbents (exchanges, banks, regulators, governments and investors) will make finding these solutions exceedingly difficult. I hope I’m wrong. Until then, be careful out there (and think about re-allocating some of your capital to the private markets; you’ll sleep better at night!)

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  • Thomas Barker

    It's interesting that most of the complaints seem to be for the US market, where dividend yield or P/E valuations are more stretched, rather than the UK or Europe where valuations are seem reasonable.  At some level of premium over the likely discounted cash flow, any asset is going to start behaving like a casino chip.  AMZN (the example) has no dividend and a P/E of 94 !

  • I remember back in 99/00 where analysts came up with a "peg" ratio to help explain PEs of 500+ lol.

  • Thomas Barker

    " .... Once a day profnath set their price to be 0.9983 times bordeebook’s price. The prices would remain close for several hours, until bordeebook “noticed” profnath’s change and elevated their price to 1.270589 times profnath’s higher price. The pattern continued perfectly for the next week  .... "

    http://www.michaeleisen.org/bl...

  • Reminds me also of the amusing fly-catching that one trading algo seems to do to attract another in some of these charts: http://www.zerohedge.com/artic...

  • It's unusual to hear you arguing in favour of more regulation, not less.

    As you say, if the presence of high-frequency trading algorithms merely increased liquidity and thus helped price discovery then there would be less volatility rather than more. Thus we have to conclude that provoking volatility is a design goal for the algo, and that this benefits *all* the HFT players. Without additional regulation we can't say where this will lead - algo strategies might evolve in any direction, including even more volatility. But always around a price that reflects some sort of consensus about underlying value, surely?

    But isn't the market capable of finding its own solution to this? If a lot of "traditional" investors want an instrument that reflects the underlying value of a share minus short-term volatility then the market will supply one. Maybe it already exists, I'm no expert.

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