Wednesday, August 5, 2009

High Frequency, Low Fidelity


A few years ago, my wife and I traveled to my college reunion, and we attended one of several terrific classes provided by the university for gathered alumni. One such class, given by the Yale School of Management, presented studies of the psychological factors that skewed the stock market, particularly the practices of amateur day traders, away from a clear “economic” reaction to market conditions and company values. YSM had gotten their behavioral tracking numbers down so well that their mathematical formulae began to provide greater predictive information in company values and market direction than the projections of the most sophisticated analysts at places like Morgan Stanley and Goldman Sachs.

So when the investment houses began to adopt the YSM system as one of their market measurements, and as psychological variables began to guide the pricing structures as set by the institutional buyers, as everybody started doing it, oddly the ubiquitous use of psychological factors eventually rendered them vastly less useful. Since the institutions, the champions of rational value-analysis, were now deploying the irrational elements of human behavior in their market activities, this mass flood of new behavioral data began to mirror the rational market predictions as well… and to a measurable extent, the behavioral data effectively neutralized themselves.

In short, the stock market will give an edge to you if you have some specialized insights, but when everybody has the same access to the same insights, that which was special when only a few used it no longer provides an analysis edge in predictive value. And that is the problem with the U.S. capital markets today… and it has been for several years. Instead of investing in good companies, with good managers and great ideas, our “best and brightest” (in the big financial institutions) are in the markets for a quick buck (and a mega-bonuses) by second-guessing market trends and making quick trades in and out of the market on an alarmingly short term strategy.

This is precisely how you can explain a soaring stock market amid an economy, driven 70% of consumer activity, where consumers have effectively stopped buying all but the essentials. It’s not real or sustainable until the underlying fundamentals correct themselves, factors long lacking in this managed depression. But what is the new “sinister force” du jure? The use of supercomputers, programmed with micro-second data analysis software that spots trends, identifies momentary gaps and finds the best stocks to reflect those flashes of opportunity, all in literally nano-seconds – and the same computer will also implement the buy or sell recommendation without the intervention of a human intermediary.

The advantage accelerates when you are a big institution with a computer right next to the exchange (time matters, even tiny fractions of a second!) and are permitted a further fraction of a second access to electronic information before anyone else as a reward by that exchange for volume trading. But increasingly, the top financial players are each creating and deploying such mathematically sophisticated software used in such supercomputers to trade on their behalf. Analysts’ inputted data, constantly updated, melds with the instantaneous analytical capacity of these systems to produce very quick highs and often quicker lows in the overall market. This is one of the major reasons companies like Goldman Sachs and JP Morgan have made so much money in a very down market and are now paying out mega-bonuses to their top financial employees.

The July 31st Washington Post: “With high-frequency trading, high-speed computers, programmed with proprietary software based on complex algorithms, spew out a constant stream of orders to buy and sell millions of shares of stocks and other securities, hoping to make a penny on each trade. Although high-frequency traders employ any number of different strategies, what's common to virtually all of them is that shares are usually held for only minutes or even seconds.

“Because it thrives on volatility, high-frequency trading has generated hefty profits over the past two years for hedge funds and proprietary trading desks, and hefty bonuses for the quants who oversee it. It has also generated lots of fees for the exchanges and brokers who process the trades and are now locked in a high-tech arms race to see who can install the biggest, fastest computers to execute them. This has even generated a caper worthy of a David Ignatius spy novel: federal officials recently charged a former Goldman Sachs executive with stealing the firm's closely guarded high-frequency trading software on his way out the door.”

This is also a practice that does not serve this country at all – it is based on high speed market manipulation through systems not available to most traders and is further distorted by favorable access accorded these institutions which cannot be replicated by smaller institutions or individuals. As the systems become more widespread, their value will probably decline (note my example above), but the damage that they are capable of inflicting in the meantime may be huge. Mass use of such software can most certainly result in a market spiral that can collapse the exchange at a speed unheard of in the past. Wild gyrations, up and down, become the uncontrolled excess reflecting a battle of the supercomputers.

What America needs is jobs, business that work, values that we can produce… not the mere ability to generate financial machinations – profiting wildly in the process – that do not add an ounce of real value to an economy in dire need of tangible worth. This preoccupation with the financial system at the expense of genuine business value is what created this economic meltdown in the first place. If there is an arena that merits regulation, I cannot think of a more obvious place. The injustice of the manipulation of the system by the rich and powerful few at the expense the rest of the nation is simply intolerable.

I’m Peter Dekom, and I approve this message.

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