Tuesday, 11 September 2012

The emperor's new clothes

Somebody has to say this. Like the kid from the proverbial Hans Christian Andersen's tale, who exclaims that the emperor is actually naked, I will go ahead and say it. Stock markets have become a weapon of mass destruction.

The original purpose of stock markets was to become efficient allocators of capital. Capital was always scarce and economics needed a mechanism where capital would be pooled from investors and allocated to the most efficient users of capital. Voila, the stock market was born. It is important to remember why this mechanism was created in the first place.

One of the most important benefits that stock markets provided was liquidity. Investors needed liquidity to be able to withdraw their investment without affecting the company that they invested in. Contrast this with property markets which are not very liquid - try selling a property, especially in India. Liquidity was , and is, provided in stock markets by speculators. They performed the useful function of ensuring liquidity and hence were tolerated even though speculation climbed to above 90% of all trades in stock markets.

But witness what has happened in the last 10 years. Most of the trading is now done by computers against computers. By automatic trading ; not by human decisions. A concept called High Frequency Trading has come into being. Big trading firms have invested in creating a competitive advantage where their automatic trading computers can gain a few nano seconds advantage over competition. I am not exaggerating  - a few nano seconds advantage. A millisecond is considered an eon in high frequency time. Two critics of the way stock markets function today - Sal Arnuk and Joseph Saluzzi have been laughed at for proposing a solution that firms honour the prices they offer for a share for at least 50 milliseconds.

Software is vulnerable, as all of us know. Knight Capital, an American Equity broker, started using a new software programme to execute its trades on 1 August. Within one hour of the market opening errant trading had cost the firm $440m. It virtually went bankrupt and only escaped from near death at a huge cost and will never be the same again. Such events are now becoming not uncommon. In May 2010, The Dow Jones Industrial Average plunged 1000 points in minutes and for a brief period Accenture was trading at 1c a share !

Such high frequency trading is not performing any usual social function. They are not based on a company's future or a view on the economy. This is pure gambling based on tiny changes in price. The amounts of money are so huge - several times the GDP of the world, that a catastrophic systemic failure is a real real risk. It almost seems to be a question of when, and not if.

I submit that the original purpose of stock markets has got grossly distorted and weakened. Before a meltdown occurs, it is important to go back to the roots - stock markets have to be reborn as efficient allocators of capital and not a Las Vegas on steroids. Its better to do this before the calamity hits, rather than after.

I say this loud and clear. Almost everybody on Wall Street, Dalal Street, etc etc, is stark naked. Unfortunately, that is not a pleasant sight - potbellies, warts and all. What does it say about our society, when its best brains are running naked and looking as ugly as hell. This naked horde might do well to remember , as The Economist points out, the advice of Warren Buffett, the most successful investor in history who says that his ideal holding period for shares is for ever.


gils said...

chandramuki la vadivelu "pei irukak illaya...nambalaama koodaathaa" nu kekara mathiri...share market venumaa venaama? nambalaama koodathaa?

Asha said...

I know nothing about stocks and shares. But love to understand economics and the stock exchange. But eveything goes over my head. Point if you have made any elementary post for people like me.

sriram khe said...

How crazy, right? Sheer gambling, and not "investment" based on the potential for future earnings and losses and all the traditional parameters. And, yes, as you point out, whether it is Harvard or IIT, there is a steady flow of grads from these places to these modern gambling parlors.

Oh well ... perhaps we are getting closer and closer to the Matrix world (am eagerly waiting for the next one from the Wachowskis--Cloud Atlas)

BTW, re. the Chandramukhi movie ... last December, I watched it in India because my seven year old nephew was watching it over and over and over and ... now, thanks to Gils' comment, I tracked it down in YouTube and, well, here it is:

Ramesh said...

@Gilsu - I was going to ask you who or what is chandramuki, but Sriram has very kindly clarified !! You have better arenas to play in gilsu ; why boring old stock market. Kollywood is your place.

@Asha - The stock market is beneath somebody who designed PCBs to go into space rockets !! This is grubby money making (or losing) of the messiest kind

@sriram - Its amazing that America is so prim and proper with regard to traditional gambling, but is perfectly content to let the most virulent form of it go wildly unchecked.

Vincy said...

I wish I had someone telling me all these some years back. In the organisation I used to work earlier, we were issued ESOPs ( Employee Stock Option Plans) through which I was alloted a whole lot of stocks at a much lower price than the market price. And ESOPs were also given as incentives for great performance. The org was doing pretty well then and so I invested in those stock options and looked at them as my investments for retirement. I was blown away completely when the man who infamously was riding the tiger made the confession and all my stocks and their value went down the drain. I am yet to recover from the losses. Good lesson learnt. I think twice before i utter the word stock these days. :-) once bitten twice shy :-)

Agree with Sriram's terminology - modern gambling parlours.

Ramesh said...

@Vincy - Oh. That's a bummer. Very rare case and a pity it happened to you.

It doesn't mean you should stay away from stocks. Its one of the few investments that will beat inflation in India. The trick is to invest for long term, invest in sound companies and diversify investment. What not to do is day trading, trading on tips, punting, etc etc.

Sandhya Sriram said...

the emperor is as important as you make him. i always feel we have given too much of importance to the stock markets.

this is typical example of how the tool has become so important that the purpose by itself of why the tool exists is itself lost

Ramesh said...

@sandhya - True. Stock market is overhyped, but the issue I mention is equally applicable to debt markets, Forex market, commodity markets .... Everywhere its the same thing.

sriram khe said...

So, this should make for good theatre!:

"An insider of the secretive world of high-frequency trading is set to attack that industry Thursday on Capitol Hill, giving lawmakers a potential road map to address practices that critics say can put ordinary investors at a disadvantage and the financial system at risk. ...
Mr. Lauer is part of a growing chorus of industry insiders blowing the whistle on approved trading techniques that they say are designed by the traders who derive the most benefit. ...
He plans to tell senators how he came to believe that high-speed trading has made the market less fair for many investors ..."

The complete WSJ report here:

Ramesh said...

@Sriram - Yes, there are loads of people worried about the situation although not always for the right reasons. I care two hoots about the unfair playing field for investors - anybody who enters these markets should know this. My chief concern is that their antics can bring down the whole financial world - with grave consequences for everybody. They have to be reined in because its like handing over the control of a nuclear power plant to a bunch of monkeys.

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