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Danger in the Market: The Sharks Have Computers Now

April 10, 2011 by White House Chronicle Leave a Comment

Jim McTague, Washington bureau chief of Barron's, the stock market newspaper, is as gentle a journalist as pads the halls of Congress or pops into the briefing room of the White House. But he has chosen to poke a tiger with a short stick in his new book, “Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market into a Casino.”

The book is likely to stir regulators, legislators and traders. It tells a sad and frightening story of inept regulation, congressional good intentions gone wrong, and technological excess.

McTague says a very small number of trading firms, using highly sophisticated computer programs, have upended a once efficient market for the allocation of capital and turned it into a casino operating at electron speed. The losers, he says, are traditional brokers and small investors who

do not stand a chance in a market dominated by trading that moves faster than information can be released to the public. The much-loved New York Stock Exchange “ticker” now lags actual computer trading, McTague says.

Currently, 70 percent of all trades are executed by hugely complex algorithms written in computer code by mathematicians and physicists, who have abandoned their traditional lines of employment for the gigantic rewards of Wall Street.

In a chapter headed “The Road to Ruin,” McTague says, “The history of U.S. investors and their experiences in the equities market has all the earmarks of an abusive relationship, and it will require an eminent psychiatrist several hundred pages to explain why the battered investors return to the market time after time after their previous drubbing, knowing in their hearts that they eventually will be brutalized again.”

The great example of how dysfunctional and dangerous the markets have become is May 6, 2010. It is the day of the “flash crash,” when the so-called high-frequency trading computers lost their electronic minds

There are stories about what triggered that day of disaster; but, in the end, the thing is that it did happen. Computer trading ran away with the market and nearly sank it. In a 10-minute period, many classy blue-chip stocks were nearly wiped out. For example, Accenture, trading at around $42 was reduced to a penny.

When trading was suspended that day, the crafty computers simply moved the trades to other exchanges, such as Frankfurt and London. Eventually most of the lost value was restored, but not the lost confidence.

The computers had outsmarted themselves. Their programs rely not only current trading conditions and knowledge of specific stocks, but also on historical data. “The computers read the newspapers and they have information from historical reporting as well as today's business pages,” McTague says. The problem is they do not have any newspapers from the 1920s; and when the crisis of May 6, 2010 hit, “the computers did not know what to do, so they began liquidating.”

This sad tale begins in the 1970s when Congress, with good intentions, sought to make all stock markets more competitive and the New York Stock Exchange in particular a more open and consumer-accessible place.

In 1975, the reforms were enacted as amendments to the basic securities law of the country. Over the years, the regulatory agencies implemented these reforms. According to McTague, they botched the job.

The reformers also misjudged the impact of computers. Their idea was that they were going to make the markets more egalitarian. Instead, they have favored the greedy few at the expense of the small investor, broker and 401K pensioner.

McTague has no magic solutions, nor does he suggest that people with excess cash stuff it in their mattresses. But he has some tips which he follows himself, including:

  • Do not trade early in the day because that is when most small investors put in their orders, and the sharks are waiting to eat them in the afternoon.

  • Do not leave your research to other people.

  • Be brave and hold on, if you are confident in the stock you have invested in. But do not hesitate to sell it if necessary.

In the short term, computers are making nonsense of the old advice to buy and hold, so investors have to watch their stocks carefully and do their own homework.

Broker-turned-journalist McTague is still trading himself, aware of the dangers. He concludes, “… there is no sure-fire method for a retail investor to beat the market. It has become a shark tank and we are the anchovies. Every time you buy or sell a stock, you are rolling the dice and hoping for a good outcome.” — For the Hearst-New York Times Syndicate

Filed Under: King's Commentaries Tagged With: Barron's, computer trading, financial regulation, flash crash, Jim McTague, New York Stock Exchange

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