Howard Gold's No-Nonsense Investing
Forget Knight, there is no investor confidence8/10/12 8/10/2012 (MarketWatch)
NEW YORK (MarketWatch) -- Last week's implosion of Knight Capital, the biggest market maker in U.S. equities, created anxiety among traders and investors alike. The latest in a series of electronic blow-ups and glitches, it again raised the question of how reliable markets are in an age of high-frequency trading.
But watching it unfold online and on CNBC, I was struck by the disconnect between the pros whose opinions populate the business media and those of average investors who are supposedly one of the main reasons these markets exist.
The pros and the media commentators who echo their views were obsessed with "liquidity" and "restoring investor confidence." Average investors might as well have been living in a parallel universe: To them the markets are hopelessly rigged and they have no confidence left to restore.
Ironically, Knight Capital's near-death experience was far less scary than the "flash crash" of May 2010.
Yes, a rogue program made bum trades in nearly 150 stocks, losing the firm $440 million in about 45 minutes. But Knight survived through an infusion of $400 million through
Big institutional customers, who abandoned the platform for a couple of trading days, came back. Regulators were caught flat-footed, as usual, but their response afterward was pretty good. Knight Chief Executive Thomas Joyce asked SEC Chairman Mary Schapiro to reverse the errant trades, but she refused. There was no systemic threat here; Knight had made its bed, now it would have to lie in it. Finally! Read 'Flash Crash' rules made Knight keep bad trades.
In the end, Knight shareholders were almost wiped out, its CEO was humbled, but it had a valuable asset that could attract buyers, so the firm survived. Even Goldman Sachs Group Inc. was its usual helpful self, swooping in to buy at a deep discount shares that Knight was stuck with.
James J. Angel, a professor at Georgetown University and an expert in financial markets, said incidents like these are inevitable with electronic platforms, just as they are with all new technology.
"Technology does fail and we need to do as much as we can to prevent future" glitches, he said. "Clearly we need to have better protections in place."
Still, he acknowledged that many investors see this as part of a bigger pattern. "It's just one more thing on top of the macroeconomy … for people to think about," he said. "Between the flash crash, the BATs crash, the Facebomb and the Knightmare, clearly this industry is running out of eyes to blacken."
Indeed. Angel mentioned only the most visible black eyes the industry has suffered over the last few years. But it goes well beyond the fear of electronic black swans.
Many investors also have lived through the dot-com bust, which followed nearly two decades when stocks could only go up (with a few exceptions, like the 1987 crash, partly triggered by electronic program trading).
In the 2000s, too many investors followed the animal spirits from stocks to residential real estate, just in time for the housing bubble to burst. Then stocks, having peaked in October 2007, followed housing down as they lost half their value in the ensuing 16 months amid the terrifying financial crisis.
Equity markets, which began a strong rally in March 2009 as the Federal Reserve started pumping money into the system, have seen their prices more than double since them and are within sight of their 2007 all-time highs.
But nobody seems too happy with this bull market, because either they don't trust it or are no longer in it. The flash crash may have been the last straw -- it signified a market out of control, where stocks or ETFs could lose half their value within minutes if something went awry.
Throw in "dark pools," the dominance of high-frequency trading and giant algorithm-driven hedge funds and you have a market that looks like a rigged game to many retail investors.
Investors have yanked $535.5 billion out of U.S. stock mutual funds since the beginning of 2007 while pouring over $1 trillion into bond funds at ever-shrinking yields and ever-higher prices over the same period.
The sentiment is well-nigh unanimous in investors' comments on MarketWatch and other investor sites. Here are some replies to a column on Knight Capital in The New York Times:
"I no longer consider stocks to be an appropriate cornerstone of my portfolio, and have moved most of my retirement funds into fixed income, precisely because, assuming I hold to maturity and make sound decisions, I know the return I will receive."
"A rigged game is unsustainable. Without rules, reliably enforced, the common pastures will be overgrazed, the fishing grounds will be overfished, and the capital markets will cease to function."
"The systematic gutting of government regulations over the past several decades which had been designed to protect individual investors has to have an impact as well....The rampant abuses we've seen since the repeal of Glass-Steagall and other Depression-era regulations demonstrates pretty clearly that the institutions involved cannot be trusted to regulate themselves."
This is pretty typical of what I hear from investors as well.
I think they may be going too far, and that hostility toward stocks may present opportunities for contrarians, but I can't really blame people for feeling this way after everything we've been through.
So, it was with some amusement that I read the prepared testimony given by Knight CEO Joyce before a House subcommittee hearing back in June, just a few weeks ago.
"There has never been a better time to be an investor (large or small) in U.S. equities. Execution quality (speed, price, and liquidity) are at historically high levels, while transaction costs (explicit and implicit) are at historically low levels," he testified.
"The U.S. equity markets are the fairest, most transparent and most liquid markets in the entire world. Remember that during the course of the last few years, with two notable exceptions, the equity markets worked flawlessly…The two exceptions were May 6, 2010 -- the so-called 'flash crash' and, more recently, Nasdaq's handling of the initial public offering (IPO) of Facebook Inc. on May 18, 2012."
I guess now there's one more "notable exception" now, but Knight didn't respond to an emailed request for comment.
"High speed computers, dark pools, etc. are not the problem," Joyce continued. "Indeed, they are the culmination of our free-market system -- competition. Competition has led to better executions (both speed and price) for investors. We should not look to impede competition; rather we should always look for ways to enhance it. That is what keeps the U.S. capital markets great."
Yes, capitalism did work in saving Knight Capital, but most investors are in no mood to celebrate the "greatness" of U.S. capital markets these days. In fact, I'm quite sure they'd be ready to give up a few pennies per share in price and a few milliseconds in order execution to get markets they regard as fair and safe to invest in again.