Your Money Matters by Thomas Sottile, Esq.
Nest Eggs Remain At Risk In Fickle,
Yet ‘Inherently Efficient’ Stock Market
The precipitous slopes of last month's stock market would bring a smile to the face of any Alpine skier--so long as he or she wasn't heavily invested.
The Dow Jones Industrial Average is a market index based upon how 30 large publically-owned U.S. companies faired during a standard stock market trading session. As of last week, it was beginning to gain ground again after having fallen 593 points leading up to the market's close on August 19, 2011. From July 21, 2011, it had been down nearly 15%. This had put the Dow in negative territory for the year and wiped out the typical investors' market gains for 2011.
Economists and business commentators blamed the sharp dip on the government's inability to reduce our national debt significantly. Sharing some responsibility for the decline was the subsequent downgrading of the United States' sovereign credit, from AAA to AA-plus, by Standard and Poor's, a U.S.-based financial services company. This means that U.S. Treasury bonds now are rated lower than those issued by Britain, Germany, France and Canada.
In his influential book, A Random Walk Down Wall Street, which is in its tenth printing since 1973, American economist Burton Malkiel writes about the uncertainty of the stock market, and the various psychological, societal and economic influences which drive it up, down and sideways. Malkiel discusses two methods of analyzing the stock market: technical analysis; and fundamental analysis. In the former, stock prices are studied in juxtaposition to what they were in the past; and correlated with many factors to try to predict what they will be in the future. Fundamental analysis looks at the fitness of the companies which issued the stocks. This requires a detailed examination of their financial statements and ability to compete successful in the marketplace. Malkiel heavily favors fundamental analysis over technical analysis. He asserts that a company's overall well-being is a better predictor of its investment value as compared with its stock's current price.
The danger for the average investor whose retirement funds might be invested in individual stocks or stock funds is what Malkiel calls, "The Madness of the Crowd." This is when speculation drives up the price of stock in one company, or in a sector such as technology or energy. But the "bubble" created by this overvaluation eventually deflates, bringing down prices faster than the Hindenburg. Experts call this a market correction while statisticians might use the term regression to the mean, which is movement back towards the market's purported true average value.
Malkiel's constant theme is that the stock market inherently is efficient. It will tolerate inflated prices and foolish conjecture for only a finite period before tearing down the artifice, unmasking the imposter, and then shouting out that the emperor really is not wearing any clothes. Great losses result for investors who bought into the frenzy.
It is a reassuring yet questionable belief that the stock market ultimately is self-regulating; with a built-in compass that eventually heads it back towards a Dow average based on the worth of the companies whose shares are traded. Market efficiency, nonetheless, has to be diminished at least somewhat by illegal activity, such as insider trading, penny-stock pyramid scams, and "pump and dump" schemes which use misleading statements to push up a stock's price before it is peddled to unwary purchasers.
Program trading, a relatively recent phenomenon which is gaining more extensive use as technology advances, has a certain but somewhat difficult-to-calculate effect on the stock market as well. The term describes trading a basket of fifteen stocks or more simultaneously by using a computer program which triggers buying and selling based upon the occurrence of predetermined market conditions.
In a recent week, program-trading volume totaled 1.3 billion, or 31.3% of the average total of 4.15 billion shares traded daily on the New York Stock Exchange. This is according to the National Association of Securities Dealers Automated Quotations (NASDAQ), which is the largest electronic screen-based securities trading market in the U.S.
Program trading allows for the instantaneous matching of buy and sell orders as per their timing, price and quantity; but often without any human intervention. It uses complex mathematical formulas, also referred to as algorithmic trading, which max-
imize the brokers' chances of realizing a gain in each transaction.
The lightning speed and automated decision-making of this type of trading shockingly came to the attention of the U.S. Securities and Exchange Commission (SEC) last year when, on May 6, 2010, at about 2:45 p.m., the infamous "Flash Crash" occurred. This was after the Dow plunged around 900 points, but then recovered its losses within minutes; and recorded the second largest intraday point swing, 1010.14, in its history. Subsequently, regulators identified the use of algorithms and high frequency trading technologies as being at least partially to blame for the roiling disruption of that day, which necessitated that trading be paused at certain intervals in order to prevent a complete market melt-down.
In response to this incident, the SEC adopted a new rule to take effect on October 3, 2011. This will assist in both identifying and obtaining trading information on market participants who generate volume or market value equal to or exceeding 2 million shares or $20 million during any calendar day in the U.S. securities markets; or 20 million shares or $200 million during any calendar month. The SEC stated further that it was in the process of conducting a broad and critical look at U.S. market structure in light of the rapid development in trading technologies and strategies.
No doubt much has changed since 1792 when twenty-four merchants gathered to form the New York Stock Exchange, agreeing to meet daily on Wall Street to trade stocks and bonds. In the 1800s, the rapid industrial growth of U.S. companies was fueled by the sale of stock to private citizens. The public grasped the idea that their paper certificates gave them part ownership in the burgeoning capitalism which became synonymous with the American dream. That vision changed abruptly for many on "Black Thursday," October 24, 1929, when the stock market crashed. It would not be until November 1954, after the nation had been through the Great Depression, World War II and the Korean War, that stock prices would recover to their pre-crash levels.
Perhaps risk is the only predictable element in any stock market analysis. But as the trading process itself becomes increasingly more complicated and difficult to comprehend in its entirety, the average shareholder who is invested for the long term must keep a watchful eye. Least her or his nest egg falls victim to an uneven playing field; or to those who might be manipulating the system for quick profits in the short term.
*
Thomas Sottile is an attorney in Media, PA. He retired from the U.S. Postal Inspection Service after 23 years as an investigator and attorney.
Nest Eggs Remain At Risk In Fickle,
Yet ‘Inherently Efficient’ Stock Market
The precipitous slopes of last month's stock market would bring a smile to the face of any Alpine skier--so long as he or she wasn't heavily invested.
The Dow Jones Industrial Average is a market index based upon how 30 large publically-owned U.S. companies faired during a standard stock market trading session. As of last week, it was beginning to gain ground again after having fallen 593 points leading up to the market's close on August 19, 2011. From July 21, 2011, it had been down nearly 15%. This had put the Dow in negative territory for the year and wiped out the typical investors' market gains for 2011.
Economists and business commentators blamed the sharp dip on the government's inability to reduce our national debt significantly. Sharing some responsibility for the decline was the subsequent downgrading of the United States' sovereign credit, from AAA to AA-plus, by Standard and Poor's, a U.S.-based financial services company. This means that U.S. Treasury bonds now are rated lower than those issued by Britain, Germany, France and Canada.
In his influential book, A Random Walk Down Wall Street, which is in its tenth printing since 1973, American economist Burton Malkiel writes about the uncertainty of the stock market, and the various psychological, societal and economic influences which drive it up, down and sideways. Malkiel discusses two methods of analyzing the stock market: technical analysis; and fundamental analysis. In the former, stock prices are studied in juxtaposition to what they were in the past; and correlated with many factors to try to predict what they will be in the future. Fundamental analysis looks at the fitness of the companies which issued the stocks. This requires a detailed examination of their financial statements and ability to compete successful in the marketplace. Malkiel heavily favors fundamental analysis over technical analysis. He asserts that a company's overall well-being is a better predictor of its investment value as compared with its stock's current price.
The danger for the average investor whose retirement funds might be invested in individual stocks or stock funds is what Malkiel calls, "The Madness of the Crowd." This is when speculation drives up the price of stock in one company, or in a sector such as technology or energy. But the "bubble" created by this overvaluation eventually deflates, bringing down prices faster than the Hindenburg. Experts call this a market correction while statisticians might use the term regression to the mean, which is movement back towards the market's purported true average value.
Malkiel's constant theme is that the stock market inherently is efficient. It will tolerate inflated prices and foolish conjecture for only a finite period before tearing down the artifice, unmasking the imposter, and then shouting out that the emperor really is not wearing any clothes. Great losses result for investors who bought into the frenzy.
It is a reassuring yet questionable belief that the stock market ultimately is self-regulating; with a built-in compass that eventually heads it back towards a Dow average based on the worth of the companies whose shares are traded. Market efficiency, nonetheless, has to be diminished at least somewhat by illegal activity, such as insider trading, penny-stock pyramid scams, and "pump and dump" schemes which use misleading statements to push up a stock's price before it is peddled to unwary purchasers.
Program trading, a relatively recent phenomenon which is gaining more extensive use as technology advances, has a certain but somewhat difficult-to-calculate effect on the stock market as well. The term describes trading a basket of fifteen stocks or more simultaneously by using a computer program which triggers buying and selling based upon the occurrence of predetermined market conditions.
In a recent week, program-trading volume totaled 1.3 billion, or 31.3% of the average total of 4.15 billion shares traded daily on the New York Stock Exchange. This is according to the National Association of Securities Dealers Automated Quotations (NASDAQ), which is the largest electronic screen-based securities trading market in the U.S.
Program trading allows for the instantaneous matching of buy and sell orders as per their timing, price and quantity; but often without any human intervention. It uses complex mathematical formulas, also referred to as algorithmic trading, which max-
imize the brokers' chances of realizing a gain in each transaction.
The lightning speed and automated decision-making of this type of trading shockingly came to the attention of the U.S. Securities and Exchange Commission (SEC) last year when, on May 6, 2010, at about 2:45 p.m., the infamous "Flash Crash" occurred. This was after the Dow plunged around 900 points, but then recovered its losses within minutes; and recorded the second largest intraday point swing, 1010.14, in its history. Subsequently, regulators identified the use of algorithms and high frequency trading technologies as being at least partially to blame for the roiling disruption of that day, which necessitated that trading be paused at certain intervals in order to prevent a complete market melt-down.
In response to this incident, the SEC adopted a new rule to take effect on October 3, 2011. This will assist in both identifying and obtaining trading information on market participants who generate volume or market value equal to or exceeding 2 million shares or $20 million during any calendar day in the U.S. securities markets; or 20 million shares or $200 million during any calendar month. The SEC stated further that it was in the process of conducting a broad and critical look at U.S. market structure in light of the rapid development in trading technologies and strategies.
No doubt much has changed since 1792 when twenty-four merchants gathered to form the New York Stock Exchange, agreeing to meet daily on Wall Street to trade stocks and bonds. In the 1800s, the rapid industrial growth of U.S. companies was fueled by the sale of stock to private citizens. The public grasped the idea that their paper certificates gave them part ownership in the burgeoning capitalism which became synonymous with the American dream. That vision changed abruptly for many on "Black Thursday," October 24, 1929, when the stock market crashed. It would not be until November 1954, after the nation had been through the Great Depression, World War II and the Korean War, that stock prices would recover to their pre-crash levels.
Perhaps risk is the only predictable element in any stock market analysis. But as the trading process itself becomes increasingly more complicated and difficult to comprehend in its entirety, the average shareholder who is invested for the long term must keep a watchful eye. Least her or his nest egg falls victim to an uneven playing field; or to those who might be manipulating the system for quick profits in the short term.
*
Thomas Sottile is an attorney in Media, PA. He retired from the U.S. Postal Inspection Service after 23 years as an investigator and attorney.
