Why Markets Are Broken and Very Vulnerable
Hope everyone is having an enjoyable weekend watching the Olympics or enjoying some R&R with family and friends. I wanted to write a quick note as some of our new subscribers have inquired about my trading strategy and overall philosophy. Some of you who have traded with me for some time have heard this before and I apologize for repeating myself ahead of time.
I started my career in financial markets in the mid 1980’s and I have lived through many different market cycles since. My career involved periods spent on the trading/money management side of the business for proprietary funds, institutional investors and private individual HNW clients as well as periods on the product development side of the business. This broad experience has given me a diverse background in the financial services industry which over the years has shaped my philosophy on trading and investing.
It should be of no surprise to anyone following the market for the past few years that the cards in the financial services “stack” are firmly stacked against the individual investor. Specifically, the traditional passive individual investor who is not involved in the day to day overseeing of their portfolio but one who dutifully invests in 401K mutual funds, pension funds and the like, with the hope that over time, the returns of “managed portfolios” managed by “pros” will beat both the returns of the broad static indices and other less risky alternatives such as bonds. For sake of this note, we will call these folks “retail” as this is the nicer of the many terms used today to describe this segment of the market which by the way is the largest segment of the US market.
For context, many of the issues that we are dealing with today have been in the making for over 70 years. It is important to understand that the investment landscape in the united states changed drastically in 1940 with the introduction of the “Investment Company Act of 1940”. This act gave rise to what we today refer to as “mutual funds” and” separate managed accounts”. If you can recall your parents and maybe grandparents attitude towards investing in stocks, I would bet that it fell into a couple predictable buckets. Following the Great Depression most individuals wanted nothing to do with the stock market.
This generation of Americans wanted nothing to do stocks following the collapse of 1929 and can we blame them? This group comprises the first bucket and these are the folks who would put their money into nothing else besides FDIC insured Cds and U.S Treasuries. The other, much smaller bucket is comprised of folks who embraced stocks but were determined to do their own research and really trusted no one to do it for them. These folks used a broker to only complete the transaction and really blamed no one but themselves for their failures or their success.
I can remember my grandfather and others family members who belonged to this group. These folks and those of like mind really dragged us out of the depression and set the course back to prosperity in the US. Ask them details about the companies they owned and they would spit them out like if they worked there!
By the late 30’s the power barons of the stock market realized that without greater participation from those folks in the first “bucket”, the US stock market would face a long and tough road back to prosperity. The creation of the investment company “mutual fund” allowed folks to invest in the market under the premise that their funds would be managed by a “professional” who would ensure diversification and proper allocation… Here is precisely where things begin to go awry for retail investors. Folks now turned over the responsibility of due diligence to an investment manager. The “set it and forget it” generation was born and fund flows back to the stock market embarked a multi decade long period of expansion.
While I don’t mean to say that the concept of mutual investment companies is necessarily bad, I do mean to say that the concept of mutual funds was created to get funds from mom and pop into the stock markets for a variety of reasons that benefitted the industry first and the investor second, many times, a very distant second.
Many funds performed well from the get go and many Americans made fortunes investing alongside professional managers. The Glass Steagall act of 1933 delineated the separation of banks and brokerage firms which went a long way to help bring back the retail investor to the market. The structure of the market was solid then and while not perfect, it did engender trust that America was again open for business and that business in America was conducted in a fair and equitable manner.
This period of expansion saw more and more Americans give up their investment decision process to a third party and even today, ask any mutual fund investor and 401K investor to name the top company in their mutual funds and I bet 8 out of 10 will not know the answer. They may guess “Apple” which is a good guess these days but the fact remains, the majority of investors in these programs have no clue what they are investing in.
There are many flaws to the investment company model or really any model today but an important one in my opinion is they invariably downplay real risk, risks which cannot be mitigated in traditional long only mutual funds. The mantra of diversification along asset classes alone is a failed risk management proposition but still today, risk is undersold to retail clients creating a false sense of security and true diversification.
Where the train really went off the tracks in the market came in the late 1990’s when the depression era Glass Steagall act was abolished with the Gramm Bliley Leach act which, along with many other things, allowed brokerage firms, banks and insurance companies to be owned by the same holding companies. What was created to prevent the events that led to the Great Depression was now torn down and replaced with deregulation and a lack of oversight of financial markets that is the direct cause of many of the issues facing us today in the marketplace. I again assert, here was a change that put profits and broad market liquidity needs first ahead of investors best interests.
This change in structure which along with decimalization of the market and many other factors, has increased overall risks to market participants. This change in market structure along with increases in computing speed have given rise to an automated market maker system which is part of what we today refer to broadly as HFT. HFT today accounts for a substantial percentage of the volume in the market and its sole function is to capture inefficiencies between the multitude of exchanges popping up all over the country.
A byproduct of this activity is that it artificially keeps bid and ask spreads narrow and provides “liquidity” for the broad market. I am not an expert on HFT and there are many in the market much more well versed on the subject. If you have not yet picked up a copy of “Broken Markets” by Joseph C Saluzzi and Sal L. Arnuk, I highly recommend you do so. The present issue facing the market is that because of the tremendous outflows from equities of the past several years following the second of two major crashes in a decade, the market finds itself highly illiquid.
The HFT volume has replaced a tremendous amount of “real” trading volume and without this participant, markets could be in for a tough period of readjustment. It is a double edged sword but one that in my opinion cuts much deeper on the HFT side than the one without it. A highly illiquid market along with poor structure is a recipe for disaster.
My point in all of this is that I do not believe investors are fully aware of what this entails. Most investors today should not be invested in capital markets because of this issue and because our industry is one that is driven by “invested assets under management”, this risk is often not fully represented to clients by their fiduciary advisors. The embedding of risk assets in non-risk wrappers have been in vogue for several years now. These so called structured CDs and notes some of which offer FDIC insurance on principal and promise to eliminate downside risk to the investor while promising a participation in equity returns are some of the most dangerous products being hocked to mainstream investors today.
Not necessarily because they are bad products, many are not, I know they are not because I designed many myself during my career. The problem is that these instruments were designed for accredited investors, not for mom and pop retail. They are highly illiquid and because of this a mark to market never represents an the actual market value for these instruments. Clients are lulled into a false sense of security every month when they open their brokerage statements and see their instruments marked to par value.
There are many traders, investors, pundits and general participants that swear by so called “trend” following systems, exotic, reactive portfolio management and even the tired plain vanilla long/short strategies most Hedge Funds employ. These along with other assorted systems are designed to do one thing and that is to supposedly reduce risk and to lull you into forking over your hard earned money with the promise that “this is the one”, the one that will allow me beat the market while reducing “risk” to manageable levels.
This is the “holy grail” of the investment business, to generate steady, above market returns while keeping risk to tight, manageable levels. I am sorry to tell you that while I agree proper risk management tools are better than none, in the end the issues that put any portfolio at the highest risk today are not addressed by any portfolio risk management strategies. The JPM so called “London Whale trader” is a testament to that, so is the flash crash of May 2010, so is the “Knight” trading scandal of last week and so will be the next event, whenever that may be. I can’t tell you when that will be but mark my words, we will have other large scale dislocations of the market in the future due to these issues.
In general, the retail investor has gotten the message and gotten “out of dodge” over the past few years. A 50% haircut to your retirement portfolio will do that to you. Nonetheless many participants are still engaged in the marketplace with very unrealistic expectations and following a false reality. This is not a popular position to take on Wall Street. It attacks the asset under management model and calls for investors to take a hard look at “real” risk.
Most investments managers, brokers and pundits have no clue what an option is besides what they may have learned in their series seven examination. Most aren’t encouraged to learn about the benefits of options because firms are afraid of the exposure that large option derived losses present. For the average firm on Wall Street, it is preferable to keep the retail client in the dark about such things while keeping them engaged in “the game” hoping the next “Holy Grail” will come along to save them. My personal philosophy is very simple, I believe the best course of action for participants today is to engage the market with smaller, more aggressive target broad market options/futures positions while maintaining the bulk of assets away from market risk .
The options strategies offer a much clearer and advantageous risk reward profile and allow the opportunity to lower “at risk capital” in the absolute. Obviously this is what works for me and not a recommendation to anyone. After all the best way to not lose money at the casino is to not go into it in the first place!