Posted by: Dwight Johnston | August 19, 2012

Computer takeover confirmed

I wrote this article about a week ago for a publication and thought I would post it here on the blog. This is something to think about. The theme of the article begins about five paragraphs in.

Computer Takeover Confirmed

Traders and market-watchers kept waiting all week for something to happen – anything. But, something never came, and anything was nowhere to be seen. The market is usually good for one or more days of big swings and volatility, but there was none of that last week. A very late rally in Friday’s trading took the Dow up 40 points from a low of -70 points; this created the only 100 point trading range for the entire week. The primary reason for the lack of action in the stock market was the lack of action in euro trading as the currency moved little last week. There were several weak economic indicators from Europe, but it’s obvious that stock traders want to wait to see what the European Central Bank President Draghi has in store for them. As you recall he is promising to “save the euro.” His first lifesaver for the euro will not be thrown until September. This could keep stocks on an even keel until then regardless of the news.

The only market that was active last week was the bond market. For the second week in a row, the bond market showed noticeable signs of fatigue. This was apparent when the U.S. Treasury came with its monthly sales of longer-term debt. Demand for the issues was the weakest in about two years. It appeared that the 10-year note might break above 1.75%, and speculative traders were talking about a move to 2% was in the cards. But the selling stopped suddenly for no apparent reason, and yields rose only slightly on the week. Mortgage rates are roughly a quarter percent off the very lowest rate of this cycle. A move to 2%, should it develop, would boost mortgage rates at least another quarter percent. This is something to keep in mind if you’re shopping for a home or looking to refinance your home.

The lack of economic news last week will be made up for this week as several important numbers hit the tapes. Retail Sales will be released on Tuesday, and this is the biggest number of the week. After three consecutive months of declining sales (the first time this has happened since 2008), economists are expecting sales to turn higher. Most reports from major retailers for July indicated better sales as back-to-school buying kicked in. This is the report to watch.

We’ll also get Industrial Production, the inflation indexes, and Housing Starts along with a number of other minor indicators. After three months of generally weaker-than-expected economic data, the numbers this week will be critical. Surprises to the downside might confirm more than your garden variety seasonal respite. Of course stock traders won’t necessarily react to bad news. In addition to having the Draghi promise to look forward to, they also believe that Bernanke will kick off another round of money printing should our economic numbers continue to recede.

I’ve talked a lot in the past about how computer trading has taken over the short-term trading in stocks. News, economics, and fundamentals are irrelevant in the world of computers. Complex algorithms, seemingly currently tied to the euro, trigger trades that amount to 70-80% of the daily volume. Some of you might be skeptical of that viewpoint, but I heard someone last week in a position to know to verify that view. The CEO of one of the largest high-frequency trading firms was interviewed on CNBC last week regarding criticism of the impact on the markets by high-frequency trading. The CEO was surprisingly direct and strangely robotic in his answers, especially when the interviewer challenged his views. He reminded me of Hal in 2001 Space Odyssey, except for the fact that the CEO had a face. He mentioned but didn’t spend much time on the common claim that high-frequency trading provides liquidity to the market. That’s a farce, and everyone knows it.

To his credit, sort of, he cut to the chase and stated flatly that the individual investor has no business trying to trade this market short-term and should stop trying. He said the computers are in charge now and high frequency trading is only going to grow in its dominance. When challenged by one outraged interviewer, he said it’s okay if investors want to buy stocks for the long-run based on fundamentals. (Generous of him don’t you think?) He said the computer programs don’t recognize or factor in anything like economic or earnings data, but individuals can’t compete with computers in the short-term. Some of the questions got pretty intense as the interviewers were probably trying to shake him. After all, CNBC depends on individual investors tuning in daily in hopes of getting investment insight to make money. But there was no shaking this guy. He simply calmly restated his positions that computers are in charge now, and there is nothing you can do about it. I swear the guy was a robot or cyborg. He went on to say that the algorithmic programs “learn” as they trade and will always stay several steps ahead of human decision making. I give him an “A” for honesty but an “S” for scary.

This is not really a surprise if you’ve observed the markets over the last couple of years. It’s clear that rational human beings aren’t making these decisions. Now, if we can just get CNBC and business scribes to stop saying “investors bought today” or “investors sold today.” Investors have nothing to do with it. This is not to convince you to get out of stocks, but the cyborg trader has a point. Trading in the short-term has gone to the computers. The only reasonable way for individual investors to stay in the stock market is to invest in a diverse portfolio of funds or stocks that can stand the test of time over the long-term.

But make no mistake about it, short-term trading can impact the long-term. Big downswings in the stock market can undermine business confidence and can unnerve and drive away individual investors in stocks at just the wrong time. Big upswings in stocks for no good reason can also lure investors into the market at just the wrong time. Stock prices can also influence interest rates, even for short periods of time, which can impact your mortgage rate. The cyborg trader seemed to suggest we go about our lives and leave the stock market to them. It’s not as benign as he made it seem. Not only does the short-term influence the long-term, but as computers become even more dominant the risk of a repeat or worse of the “flash crash” of 2010. The regulators are the only ones that can fix this, but they seem unwilling to address the issue and are just hoping that nothing “bad” happens. In this regard, they remind me of the leaders of the European Union. They are just hoping nothing bad happens. Hope is good, but it’s not a solution.

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