It was a brutal August for stocks around the world. U.S. equities posted their worst August since 2001, with declines ranging from 4% to 6% on the major exchanges. The reasons seemed simple enough: confidence in the economic recovery sank this summer as unemployment remained stubbornly high. Few investors and economists believe that the run of strong corporate profits can continue if the U.S. and other rich world economies sputter.
Stocks roared back in the first week of September, but the story of the year is anxiety, not hope; mutual-fund investors have been pulling money from equity funds to the tune of billions. After the carnage to 401(k)s over the past two years, the recent weakness and unpredictability of stocks have led many to conclude that the premature 1970s prediction of the death of equities is at last coming true.
That would be no small matter. The long-term strength of stocks is vital to the health of state pension plans, education and charitable budgets funded by endowments, and household net worth. With market capitalization exceeding GDP in the U.S., what happens to stocks affects not only sentiment but also the actual ability to spend, especially if you depend on dividend payments that are also being cut. But while market sentiment has become deeply bearish and pessimistic and some have been scared off investing individual investors are like Mark Twain: reports of their death are an exaggeration. The recent downdraft is being driven not by investor flight or macro forces but instead by an astonishingly small number of professional investors and their computer programs.
Tales of families liquidating their holdings make for good copy, but in truth, aside from shifting some money from U.S. funds to others that invest abroad, individuals by and large have done nothing over the past year as they try to assess which direction the wind is blowing. Reports of equity-fund redemptions reaching several hundred billion dollars make it seem as if there is a stampede for the exits except that the industry amounts to nearly $11 trillion, which makes even a few hundred billion much less significant than it seems.
That said, there is something going on in marketland that should trouble us: the volume of shares traded has been shrinking. At the same time, the number of shares traded by preset computer programs has increased, with estimates ranging from 40% to as high as 70%, according to a paper prepared by officials at the Chicago Federal Reserve.
High-frequency trading is a relatively new phenomenon. It is not to be confused with the day-trading your cousin or nephew does with the zeal of a multiuser-game addict. It is not just a case of buying shares, waiting for a pop of 1% and then dumping them a few hours later. It is a legal system of jumping in front of other trades in the market, using powerful computers and algorithms, and only a few firms are able or willing to do it. Because shares can be priced to several decimal places, these programs allow millions of shares to be bought and sold by computers in seconds for tiny profits per share that add up to hundreds of millions when multiplied.
With overall volume low and the percentage of high-frequency activity heading higher, prices are being determined by programs that move faster than any human could, eking out fractions of pennies per trade. The much respected investor Doug Kass has warned that the prevalence of high-frequency trading makes it increasingly difficult to invest based on fundamentals. The so-called flash crash in May, in which the Dow swung nearly 1,000 points in minutes before recovering, has been widely attributed to high-frequency programs. You know something is amiss when professional traders and hedge-fund managers complain that they can't catch a break in the market. While few tears will be shed for their plight, the dysfunction of markets should concern all of us.
But for all the legitimate worries about high-frequency trading, I remain unconvinced that the sky is falling. True, a few traders and programs have the run of the equity markets, and their need to sell, sell, sell to make money naturally leads the markets down in the absence of long-term buyers and right now, there aren't many of those around (though plenty of folks are buying bonds). None of this is so surprising. Less than two years ago, the global financial system nearly imploded, and caution is now king. Eventually, investors will again test the waters, either because bond yields offer no real return or because a new generation unburned by the past takes a new interest in stocks. Equities aren't dead, and individual investors haven't fled in droves, but professionals and fancy computer programs are adding one more burden to an economy that can ill afford it.