Sunday, June 21, 2009

WSJ: How Traders Killed Value Investing

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Going through some older pieces that I had not had time to bring to the blog; here is an interesting piece from about 10 days ago regarding the dominance of the shorter term time frames in our A.D.D. society. Combined with hedge funds where 2-3 months of underperformance starts to get investors rankled, and the rise of ETF domination in the leading volume instruments day in and day out, and we have a potent combination.
  • Long before the June 1 negotiating deadline, it became quite clear that General Motors Corp. was headed for bankruptcy. Its debtholders were going to get crushed. The shareholders were wiped out. Except that they weren't. As the deadline neared, shares of GM did a funny thing: They kept trading at more than $1 each. They didn't disappear.
  • Last month, shares rose a few pennies during a given trading day and fell a few pennies the next. Taken as a whole, GM shares reflected nearly $1 billion in value that did not exist. Even today, with GM in bankruptcy, the automaker's shares are trading around $1.50.
  • Market analysts seem baffled, but trading in GM reflects the sea change that's taken place in the markets during the last decade. Simply put, the market has slowly given itself to short-term traders. The traders control volume, and whoever controls the volume controls the price.
  • The old notion that profitable companies with good growth prospects should have rising share prices -- and that failures like GM should be gone, or at least trading in the pennies -- is history.
  • Today, a hedge fund investing billions using a quantitative formula can stall a stock; a couple hedge funds aligned can turn a profitable company into a Dow laggard. [Joe Saluzzi Comments on HAL9000]
  • It wasn't always this way. Before the machines..... took over Wall Street, stocks were evaluated by an underlying company's prospects. Buy-and-hold investing ruled the day. Investors such as Warren Buffett and Bill Miller were the models.
  • Those fellows are a far cry from this generation's masters of the universe. Traders are in charge now. They rule the market. They dominate volume. That stock you bought because you thought the company was in good shape? It's a pawn in the hands of a computer model or some supertrader like Steven Cohen at SAC Capital Partners or Bridgewater Associates' Ray Dalio.
  • To move a security, they don't need to own it. They can have a short position. They can put an order to sell 1 million shares in a dark pool, those anonymous marketplaces that operate outside the walls of the exchanges. They can own options or futures contracts.
  • The buy-and-hold guys are still there, but lately they've been less successful than their hedge-fund counterparts. Mr. Buffett and Mr. (Bill) Miller ride the wave of the overall market, hoping that their undervalued holdings will someday be valued by investors. Quants, hedge funds and today's new breed of trader can turn over their holdings in a day or even just a few hours.
  • Slowpokes like Mr. Buffett and Mr. Miller don't bring Wall Street enough fees for the brokerages to care about them. For all the success markets and regulators have had in slashing trading costs, those reforms have inadvertently hurt small investors.
  • As spreads on the exchange have shrunk, trading margins squeezed middlemen on every transaction. The best way to offset those losses has been to increase the number of transactions. Brokers have been happy to step up to heavy traders such as hedge funds and provide margin loans. Those loans not only increase volume, but carry more lucrative fees. Brokers have been happy to step up to heavy traders such as hedge funds and provide margin loans. Those loans not only increase volume, but carry more lucrative fees.
  • The special attention paid to big traders doesn't only distort the market, it leaves fewer resources for investors with longer time horizons. During the last year, about 2,000 sell-side research analysts -- the guys paid to inform investors -- have exited the business, according to an earlier report in The Wall Street Journal.
Hello HAL9000 - we meet again
  • Program trading, which mechanizes a variety of trading strategies, accounted for about 30% of volume on the New York Stock Exchange in May, compared to 10% a decade ago. It was just 4.6% for the same month in 1989.
  • A 2007 study by the consulting firm Greenwich Associates found that the credit derivatives market -- the vast network of agreements and contracts that bet on debt -- now drives the pricing of the corporate bonds that underlie those derivatives, a development akin to the rabbit chasing the hound. Money managers have complained this trend is making corporate bond prices more volatile. The study concludes: "In many ways, hedge funds have become the market."
Conclusion
  • The market needs both (traders / investors). Traders, after all, provide regular price discovery and the other side of the deal. They keep the market moving, but they've also replaced investors as the market's driving force. Don't bet on that changing anytime soon.
[Mar 31, 2009: Doug Kass - The Death of Buy and Hold?]
[Aug 14, 2008: Logic - Useless?]

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