Kill the Quants Before They Kill Us

This commentary originally appeared on Real Money Pro on Aug. 24 at 9:30 a.m. EDT.

Here we go again.

Those quantitative, high-frequency traders that utilize computer programs to focus on price-momentum-based trading "strategies" and the uber leveraged ETFs have retaken control of the wheel.

Neither strategies nor vehicles have any 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.

They were back in force on Tuesday afternoon, when the DJIA advanced sharply from being up by about 150 points at midafternoon to closing with a gain of over 300 points by day's-end.

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 downside and on the upside (as they did in the last hour of trading yesterday).

Over the last two hours of trading yesterday, 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 orders during the late afternoon that could account for the sharp market advance. By contrast, my contacts in the high-frequency-trading community were on trading overload after 2:00 p.m. EDT, as the quants dominated the market's trading activity (almost all on the "buy side").

Two days ago, in " The Selling Storm Might Be Clearing," although I recognized the important fundamental catalysts of the recent market swoon, the growing ambiguity of worldwide economic growth, the negative feedback loop engendered by the gridlock and rancor associated with the political circus in Washington, D.C., and the fragility of the European banking industry, I also underscored that several non-economic, temporary and artificial influences have conspired to exaggerate high-frequency trading's dominance and impact in accelerating market moves and volatility.

Ever since the investment shock of 2008-2009, some of those non-economic factors, including a general de-risking in the hedge fund industry, growing hedge fund redemptions and a record level of domestic equity mutual fund liquidations, have served to reduce the role of the more stable classes of intermediate- to longer- term investors. This has created a vacuum of the more stable and two-sided retail and institutional trading flows and activity and has produced heightened volatility and a risk-on/risk-off atmosphere (which changes daily) owing to the increased presence and disproportionate role of high-frequency, momentum-based trading strategies. Some have estimated that high-frequency trading now accounts for about three-quarters of all trading!

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.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

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.

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