Kill the Quants Before They Kill Us

This unfortunate set of affairs has, in essence, transformed a relatively stable marketplace into a casino-like environment (up 400 points one day, down 400 points the next day), as investors have been replaced by machines that trade securities not based on intrinsic value decisions but on small trading edges and price-momentum-based algorithms.

Meanwhile the SEC fiddles while the New York Stock Exchange and investors burn.

I suppose one important reason why the SEC is hopelessly unresponsive is that they are literally "paid off" by the high-frequency-trading industry and its lobbying efforts have likely retarded regulatory responses. We shouldn't be surprised in the SEC's incompetence and "blind eye" -- after all, this is the agency that still can't explain the Flash Crash and, despite ample evidence and warnings, failed to uncover Madoff's and Stanford's Ponzi schemes.

The volatile, arbitrary and unpredictable risk-on/risk-off moves brought on by these disruptive strategies have grave longer-term consequences -- they are disaffecting investors across the world, as many are permanently leaving the investment house.

For example:

• Retail investors have pulled out money from mutual funds for five consecutive years, an all-time record.
• August's outflows (estimated to be close to $40 billion) are approaching record monthly withdrawals.
• Hedge funds, too, have been affected. Facing a much higher daily volatility, hedge-hoggers have adjusted their exposures and have reduced their values-at-risk by de-risking down to net levels that are back to 2009 net long positions.

I will again end today's opener with Neuberger Berman's Marvin Schwartz's well-articulated rant against high-frequency trading from Thursday's CNBC "Strategy Session" with Gary Kaminsky and David Faber:

I think the high-frequency trading is a major negative for the stock market. It is a major negative for the economy, and it does not do anything for the economy. It does not add any value to the economy. It doesn't add any social value. Charles Munger, Warren Buffett's partner, in an interview on CNN in May, essentially said the same thing.

These high-frequency traders begin the day owning nothing and end the day owning nothing in terms of common stocks. During the day, they are accounting between 50% and 60% of the volume.

There was a terrific article in The Wall Street Journal on Tuesday. The headline was "A Wild Ride to Profits." The article talked about what happened on Aug. 8, when the S&P 500 index was down 6.8%. That day happened to be the single most profitable day in the history of high-frequency trading. These high frequency traders made an estimated $65 million. While on that day, the stock market lost $850 billion of value....

The liquidity that they add to is useless liquidity. It has no lasting value. It consists of orders that are placed and that are quickly retracted. It heavily, heavily consists of front-running.

It is amazing to me the New York Stock Exchange puts up a facility right next door to their computers in New Jersey and then they lease out space to 10 or 15 or 20 of the highest so-called co-locations so that those individuals putting their computers there can get a microsecond of an advantage over their competition. If the New York Stock Exchange thinks this is a smart idea, in order to generate volume, I don't think so.

But can I go back to something else? There was no high-frequency trading four years ago. What permitted high-frequency trading, in my opinion, to occur was when the SEC removed the uptick rule -- on July 7, I think, 2007.

Right now, I ask a question, where are the regulatory bodies? We have had a major destruction in confidence. You can help restore confidence to the markets tremendously, in my opinion. If the SEC would consider reinstating the uptick rule, reinstating the uptick rule -- if you reinstate the uptick rule, you don't have to do anything else. That will bring high-frequency trading to a screeching halt, but understand that the New York Stock Exchange may not be in favor of it. The major investment banking firms won't be in favor of it. The hedge funds, most of them, won't be in favor of it.

-- Marvin Schwartz (Neuberger Berman) on CNBC's "Strategy Session" (Aug. 18, 2011)

Kill the quants before they kill us.

Doug Kass writes daily for RealMoney Pro, a premium service from TheStreet. For a free trial to RealMoney Pro and exclusive access to Mr. Kass's daily trades and market commentary, please click here.

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