This piece ran earlier today on Real Money Pro.
"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."
-- Doug Kass, " Kill the Quants Before They Kill Us"
Over the course of financial history, the U.S. stock market has served as a conduit and repository for investors and savers. It is the platform upon which new capital is raised for start-ups, for emerging companies and for existing businesses. As such, equity markets assist and are invaluable in the creation of jobs in our country and, in turn, in promoting aggregate economic growth.
But, as I wrote recently, the toxic combination of price momentum-based high-frequency trading strategies and the proliferation of leveraged ETFs has served to launch the newest forms of financial weapons of mass destruction, and they're alienating legions of investors.
Computers don't sleep, don't get tired, don't care about politics or fundamentals and don't vacation in late August in the Hamptons or on the Jersey Shore -- they just wreak havoc on our marketplace by amplifying moves on the upside and on the downside (as they did in the last hour of trading yesterday).
The de-risking in the hedge fund industry and a record level of domestic equity mutual fund liquidations have reduced the role of the more stable classes of intermediate- to longer-term retail and institutional investors. The ensuing vacuum created has produced heightened volatility and an unforecastable risk-on/risk-off atmosphere owing to the increased presence and disproportionate role of high-frequency, momentum-based trading strategies and intraday adjustments to the holdings of leveraged ETFs. (Some have estimated that high-frequency trading now accounts for almost 75% of all trading!)
This unfortunate set of affairs has, in essence, transformed a relatively stable marketplace into a casino-like environment, 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.
These financial weapons of mass destruction have taken over the wheel in a period in which there is already too much uncertainty about the economic and stock market future. These strategies and vehicles have no redeeming social and/or economic value. Indeed, one can argue that their influence (on the market's volatility) is contributing to the negative feedback loop that is threatening our domestic economy's growth trajectory.
One only has to look at the intraday price movement between 3 and 4 p.m. EDT during yesterday afternoon's trading session to understand the damage in investor confidence that is being done to our marketplace -- up more than 10 points on the
from 3 to 3:30 and then back down a like amount in the last half hour of trading -- by the randomness and unpredictability of stock movement caused by the two factors.
Once again, late in the day, I polled numerous sell-side institutional desks and a number of sizeable high-net-worth brokers, and none of them had any meaningful individual buy or sell orders during the late afternoon that could account for the sharp market fluctuations. By contrast, my contacts in the high-frequency-trading and ETF community were on trading overload after 3 p.m. EDT. My guess is that these two strategies accounted for more than 80% of the trading activity in the wild last hour of trading.
This morning I want to quantify the dimension of the loss of confidence on the part of the individual investor.
In June nearly $21 billion was redeemed from domestic equity funds. Last month, almost $29 billion was redeemed and, in August, it has been estimated that more than $35 billion poured out.
The $85 billion of outflows from June to August will likely approach the previous three-month record of $88 billion, which came out of domestic equity funds between September and November of 2008!
Thus far in 2011, individual investors have sold about $75 billion of domestic equity funds, only $10 billion less than last year's total outflows.
Astonishingly, since the beginning of 2007, domestic equity mutual funds have had net outflows of more than $400 billion (in the same period, $835 billion of fixed-income funds have been purchased! (Hat tip Steve)).That spread between stock outflows and bond inflows -- $1.235 trillion -- is unprecedented in the annals of financial history.
I fully recognize that the instability and damage to confidence caused by the impact of high-frequency trading strategies and uber-leveraged ETFs are not the sole reason for retail disenchantment with stocks. A weak jobs picture (with about 9% unemployed and another 9% working part time or just giving up on a job search), stagnating real incomes (and
), broader economic uncertainty and the ever-present memory of the 2008-09 investment and economic shock are additional reasons individual investors have developed a distaste for stocks.
Nevertheless, time is running out to stop the damage in investor confidence.
If these financial weapons of mass destruction are allowed to continue to impact our marketplace -- as they did again on Tuesday -- investor confidence will not be restored for years.
Kill the quants before they kill us.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.