This Market Is Risky For Retail Investors -- Caution Warranted

by: Michael Blair

Years back when I began investing there was no "pre-market" or "after hours" trading, at least none most investors knew about. Perhaps there were trades between dealers "off the board" but as a general rule trading took place when the market was open and actual people executed the trades in the open on the floor of the exchanges. Inefficient, perhaps, but transparent at least and the advantage held by professionals was limited to their commission edge if they had a seat on the exchange.

Things have changed, some for the better but some for the worse. Today we have electronic trading which has made errors less commonplace (although when they occur they are much larger, witness some the recent glitches on the NASDAQ or the losses incurred by Goldman Sachs (NYSE:GS) recently and John Corzine's firm not so long ago.

"Fat fingers" are to be expected on computer based trading. From time to time, I have executed a buy order when I meant to sell as my online broker's trading platform defaulted to buy when I changed elements of the order and I did not see the change in time to correct it. A few bucks to reverse the trade and a small loss, and no big deal really.

The "pre-market" and "after hours" trading is a completely different story. In my opinion, this is institutionalized insider trading.

Companies wait until the close of regular hours to report earnings or report them in the morning before the opening of trading. Most retail investors do not have access to "pre-market" or "after hours" trading or, when they do, their access is quite limited. Options traders have no access at all. The NASDAQ says pre-market and aftermarket trading is provided since the value of a company is affected by pre-market and aftermarket news. Web site "Learning Markets" says such trading is done by those who want to get a "leg up" on competition as news is released either before or after regular hours.

As a result, retail traders whose brokers do not offer them pre-market or aftermarket trading get to watch the news and listen to the reporters on Bloomberg and CNBC report on the major gain on Microsoft (NASDAQ:MSFT) shares on the news of Steve Ballmer's plans to resign or the dramatic fall in Hewlett Packard's (NYSE:HPQ) share price after weaker than expected earnings for the June 30th quarter. Both these moves, and many others like them, took place outside of normal market hours. Most individual investors, both those that were hurt by the unexpected news and those who benefited from it, were unable to do anything but watch. The trading desks at Goldman Sachs, JP Morgan and Citibank were not so limited. Without doubt, they were able to profit or limit losses on such news while their retail clients were not.

The size of the pre-market and aftermarket stock price moves are material enough that the Wall Street Journal sees value in reporting them on a separate web page. The whole idea of a "level playing field" for all investors appears to have been thrown out the window.

Add to the mix the plethora of algorithmic computer trades executed with nanosecond advantages "front running" the individual investor and supplying so called "liquidity" benefits to the market, and it is easy to see why the individual investor is reluctant to enter the market. Instead they have to rely on brokers managing mutual funds where they are penalized with relatively high management expense ratios (MER's); Exchange Traded Funds (ETFs) where the trading desk of the ETF sponsor is not only taking a small fee for the management of the ETF but also, in the case of the leveraged ETFs, trading against their clients as the mathematics of the ETF inexorably reduces the value of the units purchased. The profits from this activity are to my understanding neither included in the MER of the ETF nor disclosed in the relevant prospectus. They are, however, material at times. Instead, the disclosure documents simply state words to the effect that the "daily balancing" make it inappropriate to hold the ETF as a longer term investment. For good reason! The exponential decay of value of leveraged ETFs is pretty simple algebra to calculate and the loss incurred by the investor arising from the decay is not earned by a retail investor on the other side of the trade but by the trading desk making the ETF possible.

Of course, a few hedge funds are available to retail investors. These do not have MER's like mutual funds. Instead they typically have 2% management fees to which is added 20% of any gains in a measurement period. Hedge fund billionaires are legion on Wall Street. Several of them, including the notorious Raj Rajaratman's Galleon Fund and more recently, allegedly, Steve Cohen's SAC Capital, earn those fees and performance payments through more overt insider trading.

What is interesting about the investment business is the simple fact that it is parasitical to wealth creation since it does nothing to make companies more profitable but instead earns its monies at the expense of the investors its serves. As a result, the investment industry as a whole cannot beat the stock market averages, since it can never be more than the aggregate of the market less the fees it charges. For every institution that "outperforms" there is necessarily one or more that underperforms. The all quite accurately state that past performance is no predictor of future performance, leaving investors playing Wheel of Fortune by choosing an advisor or fund without any real way of knowing how it will turn out.

I met the head of a high frequency trading firm at a tennis resort several years ago. He said he employs a handful of PhDs in mathematics and uses computer algorithms to arbitrage share prices across different markets, clipping a few cents a trade. I asked how it was working and he said: "We have never had an unprofitable day". If that is true, it is consistent with a conclusion that is "algorithms" are not much more than getting order information a few seconds or nanoseconds ahead of the rest of the market and "front running" the incoming trades. I thought front running was illegal.

In any event, market regulators seem quite content to allow these parasitical activities to continue, and they are making a lot of people rich. A lot of other people that is, since retail investors such as myself and likely yourself are left with the challenge of finding undervalued stocks, buying them and profiting if and only if our investment theses pan out over time.

We are entering a period when the market is particularly vulnerable. Companies have shown earnings growth more from cost cutting than from sales growth as the economies of the world have expanded only slowly for several years. Price to earnings multiples have expanded as Quantitative Easing (QE) has made fixed income investments rise in price to where the interest rates offer little offset to the risk of price declines. The end of QE is in sight and its withdrawal may begin as early as next month. Many stocks are hitting all-time highs. In my view, it is a time for caution. Reduce holdings to keep cash in reserve. Buy quality and a reasonable price. Have some insurance in the form of puts or a few short positions. In a nutshell, stay sensible. Real money is made when there is blood on the floor and not when the market is touching new highs.

Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.