High speed computer trading by funds with holding periods of sometimes just milliseconds are to blame for rising volatility, the disappearance of diversification and the death of individual stock picking, and the problem is going to get worse, say an number of traders and market strategists.
“From our perch, trading customer business day in and day out, we can certainly say that high frequency trading has amplified market moves, both up and down,” said Sal Arnuk, co-head of equity trading at Themis Trading who advised the SEC after last year’s so-called flash crash. “High frequency trading does not analyze fundamental metrics of corporations. It analyzes data patterns.”
Need evidence? The S&P 500 rose or fell greater than 2 percent during half of the trading days this month. This unprecedented volatility stretch included, for the first time ever, four consecutive days where the Dow Jones Industrial Average moved more than 400 points. The CBOE Volatility Index is up 45 percent this month.
Since the recent decline really began to take hold on July 7, every sector of the market, from financials to the very different utilities, has had a daily correlation of 0.9 or higher to the S&P 500, according to Bespoke Investment Group. Even crude oil has moved in lockstep with the S&P 500, trading in-line with the equity benchmark during 85 percent of the trading days.
Trying your hand at stock picking? Over the last month, just 22 stocks in the S&P 500 are higher. One Dow member, McDonald’s , is positive over that same period, with a 1 percent return. This data begs the question: Are individual prospects for these companies simply just all deteriorating at the same time or is the mass buying and selling by computers detaching stock prices from fundamentals?
High frequency traders “hold positions between 10 milliseconds and 10 seconds,” according to a recent study in the Review of Futures Markets journal. The study estimates that anywhere from 40 to 70 percent of all volume on U.S. equities market is done by a type of computer trading, but many traders speculate that percentage has increased recently.
“Individual stocks seem to have less alpha and more beta in their returns,” said Ed Yardeni of Yardeni Research and a former chief strategist at Prudential and Deutsche Bank, in a note to clients this month. “This explains why valuation multiples have both declined and converged across different sectors, industries, and styles.”
The price-earnings ratios, based on forward analyst estimates, for the 9 major market sectors all hover around ten, according to Finviz.com. Financials have the lowest forward multiple at 8.8 and utilities have the highest at 13. Health care, industrials, basic materials and conglomerates all have P-E ratios of about 10 times estimates.
Professor Luc Bauwens of Catholic University in Louvain, Belgium, who is quoted frequently in the recent Review of Futures Markets piece, believes that computer trading could add to market liquidity, but also acknowledges it could be making markets less efficient.
“Correlation between intraday returns of stocks has increased without apparently much reason, and this may be caused by HFT driven by econometric models disconnected from fundamentals,” the paper cites Bauwens as saying.
“Since 2008 investors, whether they be hedge funds or asset managers, have learned that if you are in an individual name the liquidity disappears and you are trapped,” said Alec Levine, an equity derivatives strategist with Newedge group. “It becomes you against the [algorithmic traders] as no bank will interposition in those types of markets.”
Some of this computer trading is done on behalf of exchange-traded funds, which make it possible to buy and sell whole sectors and markets as easily as a single stock. The popularity of these vehicles is also adding to the correlation and decreased opportunities for successful stock picking, traders said.
The major players at the pure ‘HFT’ game include the firms Getco, Tradebot, Citadel, Quantlab, D.E. Shaw, SAC Global Advisors and investment banks Goldman Sachs , Morgan Stanley and Deutsche Bank, according to the journal.
“High frequency trading are firms using high speed, co-located servers at exchanges to trade ahead of bids and offers from real investors by fractions of a penny for nanoseconds,” said Jon Najarian of TradeMonster.com. “If the SEC sits idly by then the U.S. capital markets will collapse. Nanosecond trading will give way to picosecond trading and so forth. All they do is push out any other potential real liquidity provider with their fake liquidity.”
For the best market insight, catch 'Fast Money' each night at 5pm ET, and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC.
Got something to say? Send us an e-mail at firstname.lastname@example.org and your comment might be posted on the Rapid Recap! If you'd prefer to make a comment, but not have it published on our Web site, send your message to email@example.com.