Kass: Mr. Market Loses His Balance

This blog post originally appeared on RealMoney Silver on July 21 at 7:58 a.m. EDT.

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.

-- Doug Kass, " Quants Causing Trouble" (May 4, 2010)
Yesterday, the high-frequency-trading nerds were in full swing, but to the upside this time. Many interpreted the late-day rally as "the first anecdotal sign of positive trading action in some time, and it carried through into the close," as BTIG's Mike O'Rourke commented last night. No doubt, some of the action can be interpreted as my buddy/friend/pal, Mike, did, but I was made acutely aware of the conspicuous presence of high-frequency trading as a forceful factor in the late-day rally.

I have written that few complain when the algorithms take the market up (like yesterday). But I would prefer to be intellectually honest, even when the programs take the market up, and I will not stop writing about this subject until the SEC acts responsibly and curbs certain high-frequency-trading strategies.

High-frequency-trading strategies are now widely estimated to be 60% to 70% of total daily volume. On top of that, add on the substantial role of package trading for ETFs. Ergo, real buyers of stocks (individuals or institutions) are getting to be too small as a percentage of total trading to produce a balanced U.S. stock market.

There is a market void.

Flash prices to high-frequency trading must be stopped. As well, paying for bids and offers by various exchanges must be stopped.

At the core of these high-frequency-trading systems is a program that, by whatever means, tries to "run ahead" of a buyer or seller -- unlike index arbitrage, which was the link between markets in which high-frequency traders try to use advance information to run ahead.

Portfolio trading was done to accumulate or distribute at low-cost real portfolios. Is an investor paying one-tenth of $0.01 per share (or less) to trade a client or a broker who should be regulated?

The SEC absolutely has created this mess, with regulations that never envisioned essentially free access by unregulated clients that look like brokers.

The SEC has tacitly acknowledged this mess by saying five minute halts with 10% moves.

In other words, it is dealing with the symptoms not the cause.

We now have a universe of market participants of too few real investors. Investors are losing confidence in the legitimacy of the markets and are leaving the building under the not so watchful eyes of the SEC.

Kill the quants before they kill us!

Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.

Doug Kass is the general partner Seabreeze Partners Long/Short LP and Seabreeze Partners Long/Short Offshore LP. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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