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Kass: Revenge of the Nerds

This column originally appeared on Real Money Pro at 7:46 a.m. EDT on Aug 6.

NEW YORK ( Real Money) --

"These nerds are a threat to our way of life."

-- Stan Gable (Ted McGinley), Revenge of the Nerds

The increased role of the quants (and high-frequency trading), the proliferation of double and triple ETFs and the rapid growth of market trading technology have replaced the last cycle's derivatives as the newest form of "financial weapons of mass destruction."

The democratization of trading has been the mantra of the algo and technology crowd since day one.

Nevertheless, I have been warning subscribers that speed kills, owing to the dangers of these strategies, products and technology, since May 2010:

One possible explanation for some portion of the recent large and random moves is the proliferation of momentum-based, high-frequency trading accounts and hedge funds.

While the role of the traditional stock investor is to assess the net present value of a corporation's earnings and share price, many quantitative funds deride the notion of fundamental value (and ignore net present value calculations) in favor of worshiping at the altar of price momentum. The momentum-based approach, which is generally auto-correlated, tries to find repeating patterns and generally extrapolate trends by going long what is in favor and going short what is out of favor.

It wasn't always this way. For some time, most quant funds attempted to be long value and short mis-value -- some still do -- but over time, many of their computer models changed into momentum-based programs, the purpose of which is to exploit a trend in motion.

Money (especially of an investment kind) goes to where it is treated the best, and the quant funds have been getting a lot of the marginal cash flow into hedge funds over the past several years. As such (and given their high-volume methodology), an increasingly large percentage of the trading on the NYSE is quant-program-related; by some measures, these strategies account for between 50% and 70% of daily trading volume.

The net of this is that quant funds control a lot of capital, they increase volatility (in both directions), and their investment style attaches little or no value to fundamentals; instead, they utilize algorithms that worship at the altar of price momentum.

By exaggerating broader market moves as well as individual stock price moves, quant funds might be inflicting more damage than good in the efficient pricing of equities.

It's fine and dandy when stocks are rising and the "machines" distort the moves both in scope and in duration to the upside, but, as I witnessed vividly when portfolio insurance was a disruptive force in the stock market massacre of October 1987, those distortions can and will occur in either direction.

Computer-generated market programs almost always end up badly for the markets, but for now, they are adding to the fireworks and to the festivities.

As the wise man once said, "This too shall pass."

As Grandma Koufax once said, "There's no business like mo business."

I say, Kill the quants ... before they kill some of us!

-- Doug Kass, " Quants Causing Trouble" (May 4, 2010)

Fast-forward to August 2012: Following the flash crash over two years ago, we have experienced the technology- botched BATS Global IPO and the tragic (but wildly anticipated) Facebook (FB - Get Report) IPO.

More importantly and with greater regularity, we have also experienced the disruptive influence of high-frequency trading, which has exaggerated and sometimes has even dominated intraday and daily price action.

As I wrote on Thursday, the risks are acutely apparent:

When every machine is processing the same data, with the same algorithms or information access, they all make the same decision at the same time.

Welcome the stair-step price moves.

Welcome the flash crash, which was destined since the death of human floor brokers and the proliferation of high-frequency-trading strategies (served up in a vacuum of derisked investors).

-- Doug Kass (Aug. 2, 2012)

During the past week, a technology glitch resulted in a $440 million loss for Knight Capital Group (KCG - Get Report) -- that's $10 million of losses per minute! -- sending the well-known market maker scrambling to find capital or partners in order to avert bankruptcy and to continue to stay in business.

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