What is moving the markets? Computers (WSJ)

JUNE 18, 2009, 9:00 A.M. ET Automated Funds Now Dominate Stock Market; Other Traders Wary
By Rob Curran and Geoffrey Rogow
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--The U.S. stock market is increasingly switching to automatic from manual transmission, forcing investors to relearn how to drive.

Investors and pundits are left clutching at straws to explain big moves in the stock market, such as attributing a June 8 bounce to rehashed comments from Nobel Prize-winning economist Paul Krugman. The difficulty in divining a fundamental explanation stems from a structural change in the U.S. stock market: The majority of stock trades now originate with fully automated "high frequency" funds, a phenomenon that has accelerated during the market turbulence of recent years because of the relative success of the strategy.

These funds employ no traders in the conventional sense. They employ no economists or chart trackers. Rather, programmers at funds such as those operated by Citadel Investment Group and Renaissance Technologies outfit computers with strategies based on obscure mathematical correlations. Then the machines trade in and out of stocks at light speed without human intervention, a departure from the "fundamental" investing model that dominated trading for the last century.

The growth of these funds is such that institutions whose names have never appeared in the newspaper are now trading hundreds of millions of shares a day. Major hedge funds that have put other strategies on ice are opening new funds devoted to high-frequency strategies and hiring the mathematicians and computer programmers that run them. Some of the fastest-growing market makers, such as Global Electronic Trading Company, or Getco, also use the automated strategies.

With the rise of these automated funds, the stock market is more prone than ever to large intraday moves with little or no fundamental catalyst. Computers don't analyze the news (although some strategies use headlines as triggers) or seek to justify their buying and selling. Even in the relative quiet of the last three months, investors have often watched individual stocks or sectors move by 10% or more without explanation.
Two-Thirds Of Total Volume
Five years ago, less than one-quarter of U.S. stock-trading volume was generated by "high-frequency" traders, and few considered the funds more than a niche strategy, according to Matthew Rothman, an analyst of quantitative funds for Barclays Capital.

That percentage has since more than doubled even as overall volumes increased, with some estimating as much as two-thirds of daily volume now stems from these funds. The niche's role now overshadows that of mainstream brokers, mutual funds and hedge funds.

In 2007, when the bear market started, the popularity of the funds "started to take off (and went) parabolic when volatility spiked," says Bill Cronin, head of electronic sales for Knight Capital Group Inc. (NITE), a broker that serves many of these funds. High-frequency funds, whose average stock-ownership tenure is counted in seconds or even thousandths of a second, became more profitable the more stocks moved during the session, and it was one of the few areas that saw some profits even during the crash. Their success drew more capital into these model-makers, extending their reach just as other money managers lost assets and reduced trading.

For almost every other category of hedge fund and money manager, what Cronin calls the "ungodly" swings of the market caused losses.

"The volatility opened up the door to make money more easily" for the high-frequency funds, Cronin said. "Now, they're popping up like mushrooms all over the place."

Gaming The Market
Traditional money managers face the increased likelihood of seeing orders "gamed," or deliberately gouged. High-frequency funds have myriad strategies, but many depend on sniffing out "order flow" - or what hedge funds, mutual funds and pension funds that hold stocks for fundamental reasons are buying and selling.

Some conventional brokers such as Joseph Saluzzi, a founder of boutique trading house Themis Trading, consider the high-frequency funds troublesome "locusts...feeding off the equity market." Saluzzi believes the current market structure makes it too easy for a high-speed computer to expose a large order before it's fully executed.

"You have to be cognizant of the fact that these people are out there and they're making a lot of money," said Rich Gates, a portfolio manager for TFS Market Neutral fund in West Chester, Pa.

The Securities and Exchange Commission believes institutional money managers are "sophisticated" enough to trade against the machines without further regulation.

"We don't want to curtail liquidity," said Gene Gohlke, associate director for the SEC. Gohlke said it's up to the managers themselves to make sure other traders aren't manipulating their models.

Saluzzi considers the high-frequency trades "phantom volume." He questions whether the increased volumes from the funds in the last couple of years have mitigated volatility as "liquidity" is thought to do, or increased it.

The popularity of these strategies has spawned a cottage industry called "co-location," or "proximity hosting." Exchanges sell the funds "rack space" in the data centers where their servers process trades to gain an extra couple of milliseconds on the competition. Most exchanges have had to turn customers away because rack spaces are full.

To gauge the prevalence of computerized trading, the SEC may soon tag orders executed by "algorithms." Algorithms are computer programs used to slice and dice many kinds of stock orders.

The regulator did the same thing with program trading - a system of executing batches of orders in tandem. But Cronin, of Knight, said algorithms are ubiquitous for both manual traders and automated traders. The algorithm is not a strategy but an electronic method of executing a trade. Even floor brokers at the New York Stock Exchange use algorithms to trade stocks. Tracking them won't reveal the role played by automated funds in the stock market.

-By Geoffrey Rogow and Rob Curran, Dow Jones Newswires; 212-416-2179; geoffrey.rogow@dowjones.com

from Sunday's NY Times - A Long Term Investment Perspective

January 11, 2009

The Way We Live Now
Go Long

By ROGER LOWENSTEIN

In October, Columbia University’s business school honored its most famous investing guru, Benjamin Graham, with a series of panel discussions loosely connected to the market crash, which was then accelerating. The panelists, of which I was one, had contributed to an updated version of Graham’s 1930s textbook, whose signature themes are caution, avoidance of speculation and — at all costs — the preservation of capital. The day we met, the Dow Jones industrial average fell 350 points en route to one of its worst months ever.

J. Ezra Merkin, a Wall Street sage, noted philanthropist and professional money manager, seemed to embody more than any of the other panelists the fear that was gripping traders. When it was suggested that the government should stop intervening in markets and bailing out banks, Merkin rejoined that the system had cracked and desperately needed help. As the world now knows, Merkin had entrusted close to $2 billion of his investors’ money to someone even less dependable than the Dow — that is, the accused Ponzi artist Bernard Madoff. I have no reason to think that Merkin, at the time, had any knowledge of the fraud that was soon to secure his 15 minutes of fame, but that afternoon at Columbia now seems pregnant with latent connections. Perhaps Madoff’s investors lost a greater percentage of their money, and lost it more suddenly, than the rest of us. But beyond these mere matters of degree, is there really any difference?

At least for investors of attenuated time horizons, there is not. Public-securities markets are a wondrous artifice precisely because they offer permanent capital to industry and short-term liquidity to investors. Think about it: a General Electric or a Google sells stock to the public and then retains the proceeds — the capital — indefinitely. Even if the companies earn a profit, by selling more light bulbs or Internet ads, they are under no obligation to pay out the gains in dividends. How, then, do the shareholders claim their reward? Why, by selling their stock to other investors, of course. This means that, in the short term at least, each investor is dependent on the willingness of other investors to hop on board. If other investors go away, prices (even of solvent companies) plummet, to devastating effect on those who sell.

In a Ponzi scheme, there is no G.E. or Google underneath the pyramid: only air. Outgoing investors are paid from the money put up by new ones. And the game for Madoff ended, as Ponzi schemes always do, when he ran out of suckers.

In theory, stocks and bonds are more valuable than air. But when investors get hooked on trading securities (as distinct from owning them), especially ones that are overvalued, they are courting disaster. In retrospect, this was true of the legions that invested in mortgage-backed securities and in the banks that owned them, not to mention the many other companies affected indirectly. Nobody was thinking about what these companies were worth, only about the next quotation on the screen.

This was doubly true for the banks that held those wearily complex and difficult-to-value mortgage bonds. Look at the post-mortem issued by UBS, one of the world’s largest banks, which has suffered mortgage-related losses of some $50 billion (enough to bail out the auto industry several times over). Discussing one particular write down, the bank admitted, “The super senior notes were always treated as trading book (i.e., the book for assets intended for resale in the short term), notwithstanding the fact that there does not appear to have been a liquid secondary market.” Legally, UBS was a bank; conceptually, it was investing with Bernie Madoff.

There is, of course, an alternative to this madness. Which is to invest for the long term, independent of the market action on any given day or year. This is what most small investors pretended, and maybe believed, they were actually doing.

Robert Barbera, the chief economist at ITG, an investment firm, says there are really three schools of investing. There are people who think they can identify superior stocks and bonds over the long term and selectively invest in those that they deem to be undervalued. Second, there are people who recognize that they don’t have this ability and resolve to salt away a fixed portion of their savings, month after month, in a generic and diversified portfolio. Though the first approach requires considerably more talent and is not recommended for novices, both should work.

What does not work is believing you are following either strategy No. 1 or 2 when you are actually engaging in the third approach — which is, essentially, following the crowd, day by day and hour by hour. At the top of the market, investors told themselves they were disciplined and in for the long haul. Now they are selling or refraining from investing. Some misjudged their liquidity needs and have come under pressure to raise cash; others have simply lost heart. Either way, they are dependent on new money to come in for them to get out.

Benjamin Graham’s premise (which he did not abandon, even in the depths of the Great Depression) was that, sooner or later, markets will reflect underlying corporate values. Thus, he wrote, long-term investors had a “basic advantage” over others, because they could ride out bubbles and crashes rather than be gulled during such highs and lows into, respectively, buying or selling. In other words, for those who invest with prudence and an eye toward long-term values, the market need not be a Ponzi scheme. While stocks periodically go for roller-coaster rides, the earning power of the U.S. economy, albeit with serious fluctuations, endures. The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.

Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine. His most recent book is “While America Aged.”