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We're Not In Kansas Anymore!

As Dorothy said in the Wizard of Oz, "Toto, I have a feeling we are not in Kansas anymore." Well, the stock market has definitely left Kansas. It is no longer the quiet and comfortable environment that greeted our parents and grandparents. The investment environment in the new millennium is vastly different than the go-go years of the 1980s and 90s. Prices are being manipulated by forces that were not even imagined even a few years ago. Three of the driver that make this market different are discussed below.

Federal Reserve Activism

In response to the economic collapse of 2007, the Federal Reserve embarked on an unprecedented path of activism. In December of 2008, they instituted the first round of Quantitative Easing (QE1) by committing to purchase $600 billion dollars of Mortgage Backed Securities (MBS). The idea was to stimulate the economy by printing more money to purchase financial assets. The specific goal of QE1 was to drive down mortgage interest rates to stimulate the housing market, which had fallen like a rock. Before QE1 ended in March 2010, another $750 billion was spent on MBSs plus another $300 billion on treasury bills.

QE2 was initiated in November, 2010, a few months after QE1 ended. The idea was to drive down long term interest rates by buying long term treasuries. Overall, $600 billion dollar was spent on this idea.

A new twist was tried after QE2 ended in June 2011. This initiative was termed Operation Twist and was touted to be a way of stimulating the economy without printing more money. In this rendition, the Fed sold short term treasuries (less than 3 year maturity) and used the proceeds to buy long term treasuries (6 to 30 years). The objective again was an attempt to stimulate the housing market and other investments by keeping long term rates low. Initially the Fed allocated $400 billion to this effort but later this was increased by another $267 billion.

All these efforts had limited success. The economy stayed sluggish, the unemployment rate refused to go down, and the housing market had only a minor recovery. So in September, 2012, the Fed launched QE3. The idea was to purchase $40 billion dollars of MBS each month, until the economy began to improve. Since there was no specified end date, this is sometimes called QE Forever or QE Infinity. In December, 2012, the Fed upped the ante by adding $45 billion a month to purchase long term treasuries.

Thus, the Fed has committed to buy $85 billion a month of securities until the economy improves. With this amount of money flooding the markets, it is difficult for the market to go down substantially. Some of the techniques for predicting the market are no longer working because the Fed actions have substantially altered the supply and demand statistics that use to provide clues to market direction.

High Frequency Trading (HFT)

HFT typically uses computer programs to decide when to buy or sell. The HFT algorithms are typically not developed by economists but are engineered by physic nerds using exotic math that is executed on supercomputers. The main difference between HFT and other forms of trading is speed. I don't mean just fast, I mean extraordinarily fast, like thousands of transactions per second! The profit made on a single transaction can be measured in pennies or even fractions of a penny. But when you multiply the small profit by millions of transactions, you get some real money. In 2012, HFT accounted for more than half the stock exchange volume on a daily basis and generated over 21 billion of dollars in profits!

Some say that HFT plays a critical role by providing liquidity to the market. However, if the HFT algorithms decide to stop buying for a few seconds, then watch out. HFT trading was one of the main reasons for the Flash Crash that occurred at 2:47 PM EST on May 6, 2010. At that time, bids dried up. Within seconds, the Dow Jones Industrial average plunged over 1,000 points, only to recover a few minutes later.

The regulators are trying to implement rules that will prevent Flash Crashes in the future. Hopefully they will be successful. But HFT is here to stay. As an individual investor, you have to be very careful when using Stop Loss orders you set with your broker. If another flash crash occurs, many of your stops could be hit and your positions sold at prices well below your stop loss point. In the Flash Crash of 2010, some stocks went from $20 per share to pennies in just a few seconds. To avoid this, you should use "mental stops" or if you must use stops, consider using Stop Limit orders. These do not provide as much protection as normal stops but they will assure you sell at the limit prices. There is no free lunch so you must balance risk management with your other market strategies.

Hedge Funds

Hedge Funds are privately managed funds. They are not sold to the general public so the managers are free from many of the regulations that govern mutual funds. To invest in a hedge fund, you must be an "accredited investor", which means that you need a net worth of more than a million dollars (excluding the value of your home) or that you have made over $200,000 a years for the last two years. If you qualify, then you can invest in a hedge fund, but the fees are not cheap. Most hedge funds charge a fixed management fee of 2% plus they receive 20% of your profits. Hedge funds were originally started to reduce risks but today most try to maximize return on investment (which also maximizes their fees).

Like HFTs, hedge funds are typically based on complex mathematical algorithms but unlike HFT, hedge funds have a longer time horizon. Hedge funds have become popular with the top earners and the funds now have over 2 trillion dollars under management!

Hedge funds have had some spectacular successes like George Soros who amassed a net worth of over 19 billion as a hedge fund manager. Or take James Simon. He was a math whiz that founded the Renaissance Technologies hedge fund and now has a net worth of over $11 billion. The current star, according to Forbes, is David Tepper, whose Appaloosa Management hedge fund has returned over 30% per year since it was founded in 1993. Truly amazing!

But don't think that hedge funds always make money. They have also had some monumental blowups. One of the most famous is Long Term Capital Management (LTCM) that had 2 Nobel laureates on the Board of Directors. LTCM made some bad bets on Russian currency and lost over $4 billion dollars when Russia defaulted. The collapse of LTCM precipitated a market crisis which could have been much worse had not the Fed and some large banks came to their rescue.

But the losses by LCTM pale in comparison to Morgan Stanley, where a trader lost over $9 billion in 2007! Then there was Amaranth Advisors, who said that one of their employees lost over $6 billion dollars by betting on gas.

So if you are looking to invest in hedge funds, do your homework and buyer beware!

It is difficult to prove (since hedge funds algorithms are trade secrets) but some believe that hedge funds have caused some of the old fashion market timing techniques, like moving average and price patterns, to not work as well as they once did.

Yes, we are truly no longer in Kansas anymore!