Michael Lewis got most of the attention last week for his new book Flash Boys, an indictment of the high frequency trading cabal that includes not just the HFT firms but also the big Wall Street firms and exchanges that cater to them at the expense of their other customers. Before reading the book I hadn’t spent a lot of time thinking about HFT and its potential effects on the market. It seemed to me – and still does to some degree – that HFT is nothing more than a sophisticated, electronic version of front running which is certainly not new on Wall Street. NYSE specialists, market makers and traders have been front running customer orders since there have been customers. And in the old days before decimalization, the front runners were scalping eighths and quarters while the HFT guys are lucky to get fractions of a penny so it seemed to me the HFT firms had just redistributed the booty from the old timers to a new, more tech savvy group of interlopers.
After reading the book over a couple of nights last week, I was ready to take up the pitchfork and join Occupy Wall Street. Okay, that’s an exaggeration. I don’t own a pitchfork and wouldn’t know where to buy one anymore, am allergic to patchouli and think young people should wash their hair occasionally and pull up their pants. But there is no way to read this book without getting absolutely incensed about not just HFT but also what it says about what our economy has become. We are indeed a nation of “makers and takers” but the takers aren’t just the politicians and their cronies or the occasional welfare fraud (check out this case). They are pikers compared to the pickpockets and shoplifters of Lewis’ book who have turned Wall Street into a modern day bucketshop.
Financial intermediation now consumes roughly 9% of GDP versus 2% historically. Financial industry profits represent now nearly 30% of total corporate business profits which is down from the peak but nearly double the historical norm closer to 15%. Technological advances of the last half century should have increased the efficiency of financial intermediation but instead it has been used not for the benefit of the economy as a whole but rather to fatten the wallets of the people and companies who stand at the crossroads of capitalism and finance. The US economy has suffered as a result as capital that should have been available for investment – real investment – has instead been consumed or diverted to speculative activities. There’s a reason that Sotheby’s is booming while corporate investment has been on a long term downslope. It is this redistribution to the inefficient financial sector that spurs the inequality debate and makes the other form of redistribution an attractive campaign slogan.
One of the heroes of Lewis’ book discovers at one point that the emergence of HFT is a result of changes in regulations that grew out of a previous front running scandal. Indeed, he discovers that most of the scandals on Wall Street throughout history have produced regulatory changes that just lead to the next scandal. Smart people on Wall Street always find a way to outsmart the regulators; unintended consequences are a feature of all such changes. Regulatory changes may have created the opportunities for the HFT shops but the larger cause of the rise of finance lies in a monetary system that sees all problems as an opportunity to inflate. Inflation throughout history has given rise to speculation and the policies of the current Fed are nothing more than a modern day version of John Law’s system in 1700s France.
The US economy is now in its third bubble period in the last 15 years and HFT has played a role in the latest one. I doubt whether some of the bubbliest sectors and stocks could have risen to the heights they have without the assistance of strategies such as momentum ignition. The algorithms employed in HFT will also play a role as the froth comes off, increasing the volatility of the stocks they target. The NASDAQ beating last Friday came with little change in the fundamentals – where any existed – of the momentum darlings that led the market lower. Having kited these stocks to levels that made little economic sense, the HFTs will now push them down, gunning for stops and creating a little panic from which they can profit. HFTs create the illusion of activity by “painting the tape” and enticing nervous traders to push stocks in the desired direction. Up or down doesn’t matter much to the algorithms so everyone who enjoyed the ride up better buckle up for the ride down.
I don’t know whether the topping of the NASDAQ – and that is what it looks like right now – will affect the broader market. It might be that taking down the highfliers is a healthy sign and the rest of the market can continue to march higher on just the Fed’s largesse. Or it might, like it did in 2000, take the rest of the market down with it. That may depend on the economy and while Friday’s employment report offered some comfort to the “it was the snow” crowd, it didn’t keep the S&P 500 from taking a little off the top in the afternoon after making a new high in the morning. The economic data last week did look a little better but with everyone looking for an acceleration in activity it will take more than a minor bump higher to move the market.
A better indicator of the health of the economy – or at least the market’s view of it – is probably to be found in other markets. Confounding the consensus, bonds have led the way higher this year with the Aggregate index up a bit over 5% so far. Even more interesting is the move in the longest dated of Treasury bonds. The 20+ year Treasury ETF is up 8% already this year and looks to be resuming an uptrend that stretches back many years. If markets really are discounting mechanisms the Treasury market is not saying much good about future economic growth or the prospects for deflation. Even more mysterious to the consensus is the move in commodities and especially gold which has added 10% since the turn of the new year. While some elements of the commodity markets are moving on specific factors – drought in Brazil for example – a general move higher is more likely a comment on expectations regarding the US dollar. The move in gold would seem to confirm a rising fear about the potential for a cheaper currency. That also could be a comment on growth expectations. An accelerating economy in a world starved for growth should be a magnet for capital and positive for the nation’s currency.
The drubbing of the momentum stocks over the last couple of weeks is not just about HFT. Surely, there are some profit takers out there after such a big run higher. But if HFT played a role in pushing stocks higher then it will surely play a role on the downside too. Is high frequency trading shifting from the buy side to the sell side? HFT doesn’t generally set the direction of the market but is more of a trend following method that accentuates the move. If stocks are peaking and the trend is changing, the move down may prove every bit as exciting as the move up. And considering that HFT increases the odds of an accident – something Lewis stresses throughout his book – the ride down may be a lot quicker than the ride up.
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