Welcome to the Brave New World, post-November 2007, when the final regulations keeping the playing field level between individual and institutional investors were completely abolished. These regulations dampened volatility and ensured orderly markets for decades. Is it coincidence that the declining market of October 2008 has been the most violent and volatile week in history?
The regulations I refer to include the SEC’s July 2007 elimination of the uptick rule that had served investors, by dampening volatility, so well for 70 years. In its decision, the SEC said the rule “do[es] not appear necessary to prevent manipulation." Right.
After the most volatile percentage day in history, October 19, 1987, “trading collars” were placed on index arbitrage transactions via NYSE Rule 80A. (Index arbitrage was a favorite tactic of big institutions to circumvent other selling restrictions.) On November 2, 2007, however, the NYSE abolished these “circuit breakers,” writing “The Exchange is making this change since it does not appear...that market volatility envisioned by the use of these “collars” is as meaningful today as when the Rule was formalized in the late 1980s.” Right.
In 2005, in response to public complaints, the SEC took the half-hearted step of beginning to regulate naked short selling, absolutely illegal for individuals but, in an startlingly dangerous double-standard, perfectly OK for the “professional” primary dealers. Regulation SHO was allegedly enacted to curb naked short selling, requiring that broker-dealers have grounds to believe that shares will be available for a given stock transaction. The SEC’s logic seems to have been that, as long as the fox swears he won’t eat any chickens no matter how hungry he gets, it’s OK to trust the fox. Right. (In fairness, effective September 18, 2008, amid even more public outcry, the SEC decided to get tough. They warned the foxes to really, really make sure they thought they would really, really be able to get borrow the stock, this time. Really. Except that other departments of the SEC were still defending the practice in limited form as “beneficial for market liquidity...” Right.)
Add to these massive loopholes the whole idea of “program trading,” which the NYSE defines as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more." What they are unwilling to admit is that these “portfolio trading strategies” usually mean gargantuan computer-to-computer arbitrage strategies. Program trading is extremely popular with hedge funds, where traders automate strategies they could never execute without computer assistance.
On October 8, 2008, at 3:58 EDT, I captured a screenshot of the market. It was up 107.60 points. Two minutes later the market closed down 189.96 points. That’s a 300-point swing in two minutes. There was no news of interest to account for such a panic. There is no way enough individual investors or even institutions acting rationally or placing orders up to 10,000 shares could have sent the market into such a tailspin. It takes millions of shares untouched by human hands, “programmed” to sell as a certain price is touched, or the LIBOR goes to “x,” or the boss’s daughter wears color “y” to work.
I was a senior executive with Charles Schwab & Co. (SCHW) on October 19, 1987. I can tell you it was the novelty of computer program trading that was primarily responsible for the 1987 crash – and the current crash, as well. Facilitating instantaneous execution of enormous blocks of stocks, index stocks and futures resulted in blind selling of stocks as the market fell, intensifying the decline in both 1987 and in 2008.
It gets worse. As a former boss of a trading desk for a major firm, I was invited to a key conference in San Francisco the week Lehman Brothers went down. I was astonished, stunned, and shocked to find that, on the day Lehman Brothers was flogged out of business, no one cared. The only subjects on the agenda of these institutional traders were “dark pools” – trading through “private exchanges” like Sigma X, a Goldman Sachs company. These trades are never reported on the tape, but they can add millions of shares to the day’s trading volume and drive stocks up or down 5%, 10%, or 20% -- and “algorithmic trading,” a software application designed to take an outsized order, break it up into 100-300 share lots to make it look as if it is individual and not institutional trading.
If we are to reinstate reasonable trading and the confidence of the backbone of the stock markets, actual investors (rather than program traders,) we must reign in program trading, dark pools and algorithmic trading. It’s all trading. None of it is investing!
As a matter of fact, mutual funds, pension funds, hedge funds, et al, have come to admit – to themselves, at least – that they typically don’t beat the market or even individual investors. To goose their returns, they resort to flim-flammery. If you doubt it, look at a chart of options trading in any given month. You’ll find a disquieting pattern. With institutions comprising 76% of all trading (up from just 6% in 1950) the people entrusted with your pension money are resorting to rank gambling. Note from as many charts as you care to view that the week before options expiration most often tends to be negative -- due to program-selling that depresses the market so the sellers can buy expiring-in-a-week options for next to nothing. It doesn’t always happen, but the sheer volume of the transactions confirm that it is the institutions that talk about buying and holding for the long term that are doing this. Of course they want to make sure you and I are locked in for the long term – they need the float to goose their returns by buying options for a dime on the dollar, then selling them a week later in response to their own colossal underlying stock buy-programs which drive the market back up and let them take their day-trading profits on the options.
If we are to ever enjoy a reasonable market again, we must level the playing field. No naked shorting. At all. Reinstate the uptick rule. For everyone. No program trading once the market has moved “x” percent. None. No algorithms to hide actual activity. Period.
Now that you know this, what can you do to protect yourself? Two things:
- For the long term, don’t let the program traders panic you into making precipitous decisions. Their bonuses depend upon high volatility and an unfair advantage. Your future depends upon thinking longer than settlement date. So -- Buy when others are terrified. Yes, the economy is weak. So what? We’ve had recessions before. It isn’t the end of Western civilization. This, too, shall pass and, when it does, those smart enough to have bought when prices are astonishingly cheap will reap the rewards. On October 14, we began buying ETFs corresponding to the Dow (DIA), Nasdaq (QQQQ), and S&P 500 (SPY). We continued buying today. We’ll buy more tomorrow. We’ll still keep a prudent cash cushion (though I imagine a year from now we’ll wish we had bought more!)
- For the intermediate term, buy some Central Fund of Canada (CEF) or streetTracks Gold ETF (GLD), two firms that own gold bullion; Market Vectors Gold Miners ETF (GDX), an ETF of gold producers; or some top-quality gold miners of your choosing. Like today’s stock markets, which are abused by program-trading institutions, gold is also an abused, some claim a “manipulated,” market. But the difference is that gold is manipulated by government economists and bureaucrats, so we already enjoy a level playing field against an opponent like that... Governments will sell gold to keep their paper currencies from falling. If too many people rush to gold, it’s a (usually well-justified) vote of no confidence for that nation’s central bank. So be it. There is simply no way that 50 nations borrowing against their future to bail out their bankers and stockbrokers can be anything but inflationary. In the short term, the dollar may rise. In the intermediate term, it – and the other developed nations’ currencies – can only plunge. In that event, gold will keep us together.
Disclosure: Long DIA, QQQQ, SPY, GLD, GDX, and CEF.