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) 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) -- 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.

"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently."

-- Warren Buffett

To me, the most frightening element of the Knight Capital situation was the speed in which the company lost nearly a half-billion dollars, raising the question as to whether the pursuit of profits in technology (whether it is in market-making or high-frequency trading) is leading us uncontrollably down the road to ruin.

Certainly, the proliferation of double- and triple-leveraged ETFs, which further influence and exaggerate market moves, doesn't help much either.

Speed Kills

From my perch, the almost unbridled and nearly unregulated and unsupervised technological trading growth has unintended consequences that substantially offset the benefits of liquidity and lower transaction costs; now they are jeopardizing some of the same technologically intelligent companies that they are supposed to benefit (e.g., Knight Capital Group) and are further alienating investors (individual and institutional) who have already grown suspicious that the game is rigged or just unplayable.

The September issue of Wired magazine touches on some of my concerns far better than I could ever do.

Read it at your own risk.

I sure wish that our inert and inattentive SEC and other protective regulatory bodies would read this and react before it is too late.

I am afraid we have seen only the tip of technology's iceberg and its potentially adverse impact on our markets.

The worst is probably yet to come.

The machines giveth, and the machines taketh away.

Kill (and supervise) the quants and technology before they kill us.

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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