By
Joseph L.
Shaefer
:
There are two eminently reasonable ways to stop the off-kilter
spinning top that Wall Street has become:
-
Starve the Beast.
-
Allow only human beings to trade.
OK, I realize the genie is out of the bottle, so the second one
is simply not going to happen. The regulators are in bed with Wall
Street's trading desks so this eminently reasonable solution is off
the table. That leaves #1.
Market volatility has increased due to institutional day
trading, program trading, high frequency trading, and trading for
the sake of trading. Partly as a result of this hijacking of
"investing", individual investors have increasingly eschewed the
equity markets in favor of bonds, CDs, gold coins and other
non-equity investments.
But before we rush to blame banks and Wall Street trading desks
for our woes, (though they are due their fair share of shame and
blame) let's take a look at what we ourselves have done, often with
the best of intentions, that has changed this dynamic. Not that
long ago, markets were dominated by individual investors. Those
markets were considerably less volatile, and instead were
characterized by positions held for long-term future growth. Today,
the bulk of transactions are institutional (trading desks, pension
funds, hedge funds, mutual funds, ETFs, and the like) which are
explosive in nature and, for the most part, incredibly short-term
-- close of business today is a good time to flatten all
positions
Looking back just to the late 1960s, only 23% of total buy and
sell transactions were conducted by institutions. There were two
primary reasons for this. First, almost everyone working for a big
company had a pension, so the big institutions of the day were the
pension funds. They invested the bulk of their funds in debt
instruments, rather than equity. It wasn't as exciting but in that
more restrictive regulatory time, they had to follow the Prudent
Man rules, so they never forgot that the return of capital was the
first order of business, not the return on capital.
The other reality then was that individuals took responsibility
for their own investments. With no control over the pension monies,
they invested their discretionary income in equities and the
relative handful of mutual funds.
The situation today is completely reversed. Institutions account
for somewhere between 75 and 80% of all trading in any given year;
call it 77%. That would mean a complete and total reversal of the
markets known to previous generations of investors. Individuals now
contribute just 23% of total transactions. As if that isn't bad
enough, it gets worse.
Since dark pools and off-exchange trading are murky at best, we
must rely on estimates for the percent of total volume conducted by
algorithmic trading without human intervention after the parameters
for the trade have been established. Many analysts believe they
account for as much as 70% of each day's total volume. If that's
so, it means that institutional traders acting on their experience
and reason account for 7%, individuals for 23% and the rest is done
based upon models designed some time between last year and this
morning.
Is it any wonder that we have flash crashes? If up to 70% of the
average daily volume is done without human intervention, that's a
billion shares or more of potential volatility. Not all these
algorithms are designed for scalping, of course; some are hedges
against real portfolios, triggered when a mutual fund needs to
raise cash for redemptions, sold versus trailing stops as a result
of good price appreciation, etc. But let's be honest. Most of these
algorithms are designed to scalp pennies in seconds (or mills in
nano-seconds.) When enough of these automatic trades are triggered
by the same event, we see extreme volatility - nearly 20,000 such
events in the last 6 years alone, with the Flash Crash of May 2010
being the most public, if not the most egregious, example.
Earlier I said we have mostly ourselves to blame. How did we get
in this predicament? There are many answers, but three that you, I
and every other individual investor must accept responsibility for,
include:
-
The rise of corporate 401k's without, in most cases, any
Prudent Man restrictions. This is like setting a kid free in a
candy store with no guidance whatsoever on what is healthy and
what is not.
-
The false promise of indexing, which demeans every
investor's intellect by presuming all of us who don't work for
a bankster are too dull-witted to beat the market, if by no
other means than taking some money off the table when it is
appropriate to do so. "Don't trade!" Wall Street intones. "You
never know when you might miss something." My response? That
cuts both ways; I'd just as soon miss the occasional calamity,
thank you. And if I miss something good, stocks are like
streetcars - wait 10 minutes and another one will come
along.
-
The exponential growth of hedge funds To justify their
ridiculous "20 and 2" pricing (2% management fee plus 20% of
any profits they make) they don't invest in an index fund or
even, in many cases, "invest," as in buying and holding quality
companies, at all. There are a few hedgies that carry on in the
tradition of Ben Graham and Warren Buffett, both of whom ran
hedge funds (but not at 20 and 2!) But most hire 20-something
hackers whom they expect to write brilliant quant algorithms
for the black box.
The charts that follow are merely snapshots in time and cannot
reflect every external factor that may have influenced volatility.
Nor are they a complete picture of any one year or decade. Instead,
I selected the first 7 months of this year (just past) and compared
them to the same 7 months in each year ending in "2" since 1972. As
you will see, 1972 was a most appropriate starting point to study
volatility in light of the three changes with 401k's, indexing, and
hedge funds. If you believe, as I do, that there is a certain
seasonal, cyclical and secular rhythm to the markets, selecting 5
"snapshots" may be quite telling.
(click to enlarge)
The year 1972 was pre-401k, pre-index fund and pre-proliferation
of hedge funds. The S&P traded during the first 7 months of
1972 between 102 and 108. Sounds boring, but that lack of
volatility might be a welcome interregnum today. However - the next
year, in 1973, Professor Burton Malkiel wrote A Random Walk Down
Wall Street, propounding the efficient market hypothesis, positing
that prices of publicly traded assets reflect all publicly
available information. I think that's hogwash and apparently Warren
Buffett, John Templeton, Peter Lynch and a whole host of
non-academics agree, but we must concede this book was a watershed
event.
Among Malkiel's prescriptions: "What we need is a no-load,
minimum management-fee mutual fund that simply buys the hundreds of
stocks making up the broad stock-market averages and does no
trading from security to security in an attempt to catch the
winners." It seems John Bogle was all ears. The next year he
founded The Vanguard Group to do just that and in 1975 started the
fund that would become the biggest in the world, the Vanguard 500
Index Fund.
Another event was taking shape during this decade, as well. In
1978, Congress amended a portion of the Internal Revenue Code,
later called section 401(k). The law went into effect on January 1,
1980.
(click to enlarge)
In the first 7 months of 1982, the market swung a little over
12%. Index funds and 401k's were still new ideas.
By 1984, however, 17,303 companies were offering 401k plans in
lieu of pensions and we -- you and me -- were not just letting
fixed income and blue chips fulfill our pension needs. We wanted
action, which meant a proliferation of mutual funds offered with no
loads or other fees. Suddenly we wanted to see a little volatility,
because that meant more profits, right? By 1992 it was "let the
good times roll."
(click to enlarge)
Unlike the two previous 7-month snapshots, one of which went
slowly up, the other slowly down, this particular period of 1992
ended roughly where it began - but the volatility had increased
markedly. Note, for instance, that the 1972 chart looks like a
series of rolling foothills. Contrast that with 1992, where it more
resembles a series of jagged peaks and troughs.
(click to enlarge)
The result was that we had a bit of a comeuppance in 2002. We
had given many of our investable dollars to mutual funds via 401k's
-- and demanded that they outperform their peers. Here were the
fruits of those decisions: in the bear period these 7 months
covered in 2002, the S&P had a swing of 44% peak to trough --
in 7 months. This would have been the return in those index funds
that Wall Street so wants you to buy and hold. Of course they do!
If you take your money off the table, they don't have anything to
play with. The "institutional" money isn't money they have laying
around for a rainy day - it's your money. If you don't give it to
them, the Beast starves.
Worse, those who selected the go-go choices for their 401k's
(and other investable funds,) lost even more. Double-worse, we had
deluded ourselves into believing during the dot.com.bomb that tech
was the be-all and end-all to investing so we lined up around the
block to give our money to hedge funds. Each touting their
boy-wonders as the ones who could turn a sow's ear into a silk
purse.
Who invested in these hedge funds? Typically, other
institutions, like your pension fund or university endowment. Hedge
funds are far less regulated because they are sold only to
accredited investors and institutions. Remember those pension funds
that used to invest in bonds? No more. Having lost so much in the
dot-com-bom, many of them were now giving chunks to hedge funds,
trying desperately to make it all back to save their jobs.
(click to enlarge)
This brings us to the current period, of which we are all
personally and, for some people, painfully aware. The S&P 500
shot from 1280 to 1420 in the first 120 days of the year, then
plunged right back down to 1280 in the next 60. We've now seen it
roar back above 1400, so now -- where?
Everyone will have their own opinion, but I have chosen to
position our clients in such a way that they are hedged with an
ever-so-slight downward bias. I do so with equities, highly liquid
ETFs which I can sell any time, and even with a few specialty
mutual funds like the best of the long/short funds. My concern is
that this market looks suspiciously like a triple top and, worse,
is occurring at a time of maximum complacency among the investing
public. Whistling past the graveyard is no way to protect yourself
from the grave robbers at Wall and Broad.
Since we brought it on ourselves, we can, at least partially,
fix it ourselves. Of course we could petition the regulators, for
all the good that will do. (I hear Jim Morrison in the background
singing "Petition? Petition? Petition the Lord with prayer?") And
we could vote into national leadership office men and women who
share our concerns and hope they have a real life to return to so
they aren't easily co-opted by all that free Wall Street money to
get them re-elected over and over again
ad infinitum
,
ad nauseam
.
Perhaps more realistically, and certainly within our immediate
power to control: First, realize that your 401k is neither a
particularly good investment vehicle nor a plaything. We have had
clients come to us who still had money in the 401k of a company
they left ten years ago and military members who still have the
Thrift Savings Plan 10 years after they retired, instead of rolling
it to a self-directed IRA. Why would they consider letting some
pension fund give money to a hedge fund to speculate with their
money? That laziness translates to more money for the big
institutions to wreck the markets with their short-term trading,
high frequency trading, quarterly window dressing, etc.
Starve the Beast. The "institutional money" isn't theirs -- it's
ours. Don't give it to them via 401k's when you could roll it into
your own IRA. Don't just toss it into an index fund that mirrors
the biggest companies with the most liquidity that institutions
view as their personal playground. Use them when diversification is
more important than performance. And, finally, query your plan
administrators -- how much business are they giving to hedge funds
without you having a say in the strategies employed? Or your mutual
fund managers - does their charter allow them to play in the
derivatives market or give money to sub-advisors which are nothing
more than hedge funds?
Take responsibility for your own investing. Among the many
companies I believe have fallen, even in this "good" market, to
prices that make them worthy of purchasing for greater gains in the
coming months and years are: ABB (
ABB
), Total Petroleum (
TOT
), Pepsico (
PEP
), Johnson & Johnson (
JNJ
), Statoil (
STO
), Joy Global (JOY), Natural Resource Partners (NRP), Bank of
Montreal (BMO), Imperial Oil of Canada (IMO), Plum Creek Timber
(PCL), Siemens AG (SI), Weyerhaeuser (WY), Penn Virginia (PVR),
ScotiaBank (BNS), and Cenovus (CVE). I believe selecting great
companies at a good price will provide far greater reward than
playing Wall Street's silly in-and-out trading games or trusting
our future to an index fund. These firms and others like them are a
fine place to begin your own due diligence.
The markets are volatile because we outsourced our
responsibility for our own future. Take it back. The decline in
volatility will make the markets worthy of our research, attention
and success once again.
Disclosure:
We remain hedged in this volatile market. We own inverse ETFs that
balance our long equities, including some of those above, leaving
us with the nice dividends from the long side. We also have begun
writing puts against some fine companies we'd like to own,
especially at lower prices.
The Fine Print:
As Registered Investment Advisors, we see it as our responsibility
to advise the following: we do not know your personal financial
situation, so the information contained in this communiqué
represents the opinions of the staff of Stanford Wealth Management,
and should not be construed as personalized investment advice.
Past performance is no guarantee of future results, rather an
obvious statement but clearly too often unheeded judging by the
number of investors who buy the current #1 mutual fund only to
watch it plummet next month.
We encourage you to do your own research on individual issues we
recommend for your analysis to see if they might be of value in
your own investing. We take our responsibility to proffer
intelligent commentary seriously, but it should not be assumed that
investing in any securities we are investing in will always be
profitable. We do our best to get it right, and we "eat our own
cooking," but we could be wrong, hence our full disclosure as to
whether we own or are buying the investments we write about.
Disclosure:
I am long [[NRP]], [[PVR]], [[STO]], [[TOT]], [[PEP]], [[JNJ]],
[[PCL]].
See also
Lawrence Roulston Spots Gold Juniors With Bright
Futures
on seekingalpha.com