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If market efficiency matters, it is time to reduce and simplify

If the markets were ever efficient, if this theory ever had legs, those days are continuing to fade. A 1,000-point drop in a major index that was reversed within minutes, and that authorities are still at a loss to explain, does not help the cause at all. I voiced concern about the prospects of efficient markets in this space last week, pointing to the concentration of capital among a core group of participants as contrary to efficiency for a variety of reasons: excessive influence by a few, divergence of risk and reward for decision makers, deterioration of information flow. But that, as it turns out, was only half of the picture. In the other half, now crystalizing, we see the effects of a system that has become so complex that it defies understanding and, ultimately, could shake the faith of participants in the market itself. On a certain level, faith in the system and market efficiency go hand in hand, because where faith goes participants follow, and without participants the market is no market at all.

An interesting statistic: 70% of trading volume in 2009 was attributed to high-frequency trading, or the machine trading that was presumably at the core of the Dow’s 1,000 point plunge the other day. This is important for a number of reasons, none of which bode well for market efficiency. One, we see in this statistic an illustration of capital concentration – a source of market inefficiency, as I believe – this type of machine activity being conducted by the very largest of financial institutions. In addition, when the vast majority of trading activity is initiated by machines that the vast majority of individuals can never come close to comprehending – perhaps not even the institutions that support these machines – then markets themselves become inexplicable, as we have seen. Lastly, in the converse of the 70% figure is the reality, (a dangerous reality on a number of levels), that only 30% of trading can be traced to actual human investors. And this may be the first sign of faith that is gone.

If the overall market volume in 2009 had been high, one could make the case that even 30% of trading is a significant amount. This would not counter other concerns expressed – about capital concentration and out of control complexity – but would nevertheless give us reason to hope that a true market populated by multiple participants can still be alive and well for the long term. Overall volumes, however, were low, making the 30% figure particularly concerning. In absolute dollars, in actual trades, individual and personal market participation is dissipating.

And this is a phenomenon that can begin to feed on itself: Capital concentration and unfathomable complexity cause investors to lose confidence in their ability to assess risk… which makes them hesitate in their decisions… which reduces their market participation… which causes the concentration of capital into a select core base to further increase… which leads to the machines increasingly taking charge… and so on in a loop from which the final result – in the extreme – is a market that is no longer truly a market. I don’t mean to suggest that we are anywhere close to that point, but the trend is disturbing, and has some parallels in other parts of our economy and even geopolitics – a discussion of which would far exceed the scope of this very brief article – all pointing to a rapidly arising and very real need to reduce and simplify. 

Disclosure: No positions.