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High Frequency Anarchists

By Dan Denning

–What do you call an investor who knows the price of nothing and the value of nothing? An Australian fund manager!

–Yesterday’s brief outage on the Australian Stock Exchange highlighted a simple point: the stock market doesn’t always tell you the value of a business. And yesterday, it couldn’t even tell you the price.

–One especially heinous symptom of a credit bubble is that it distorts pricing information. Prices no longer reliably communicate what they’re supposed to communicate. Too much easy credit causes producers to overestimate consumer demand. They over produce, raising the prices of the real resources and inputs that go into finished goods and services. Asset bubbles inflate. Capital is misallocated and wealth squandered.

–In a roundabout way, this also causes investors to over pay now for earnings that will never materialise later. And thus valuations on the stock market become completely disfigured by the influence of easy money flows.

–And speaking of easy money flows, so much easy money regularly flows into Australian equities as a matter of course that you wonder if an institutional fund manager even bothers to look at valuations. We imagine that in the world of professional funds management, you buy stocks because it’s the easy thing to do. It’s also what you’re paid to do. And it’s also what makes stocks go up, so it’s a self-fulfilling strategy. That doesn’t make it a good one for you, though.

–There is another aspect of the share market “glitch” which bears investigating. If you haven’t noticed, there’ve been quite a few “glitches” on stock markets in the last year. There was the famous “flash crash” last May on the New York stock exchange. Stock exchanges in the United Kingdom and Italy have also experienced “glitches” in the last month. And now Australia.

–Now, one cause of these “glitches” could be that some exchanges are struggling to keep up with the astonishing speed of high frequency traders. These are traders who use computer algorithms to do their trading. As the name suggests, not only do the trades happen faster than the blink of eye, the algorithms (or bots) make literally thousands upon thousands of microtrades.

–What’s going on here? The bots are trying to capture minute pricing anomalies in the market at any given minute (or second). The profits on each microtrade are, as you might expect, tiny. But if you pile up enough of them, you might end up with a pretty big pile…without having to do any work or any thinking!

–The underlying drive behind this high-speed electronic arms race is that doing things faster gives you a small but useful advantage over the slow pokes. This fits nicely with the trend in the heavily mediated world we live in of instantly analysing and discounting what new events mean to the status quo, be it a geopolitical arrangement or a stock price.

–If you’re interested in this subject, take a few minutes to go back and read this essay we wrote on John Boyd’s decision cycles, back in 2006 after we’d just moved to the Lucky Country.  Boyd’s strategic thinking led him to develop OODA loops. They described the process of decision making in armed conflicted (observe, orient, decide, act).

–But you can see how Boyd’s cycles apply to businesses and investors too. There’s a civil war in Libya? Observed! How much oil does Libya produce and who buys it? Orient! Should I buy or sell oil? Decide! Buy unconventional energy plays in Australia. Act!

–Now digitise this process and repeat it tens of thousands of times a day. And now you can see why stock exchanges might be struggling with the massive increase in traders trying to extract every last advantage they can from trading faster. According to the Wall Street Journal, on any given week, program trading (bots and algorithms executing their programmed strategies) account for between one quarter and one third of volume on the New York Stock Exchange.

–In other words, the machines are slowly taking over. And they are not even thinking machines. At least not yet. But as this presentation shows, it’s increasingly possible to build computational grids that can, “predict the future by inventing it.” In other words, if enough of the market’s trading activity is run by autonomous auto-trading algorithms, the price action in the stock market ceases to have anything to do with values. Instead, the trading patterns create the dominant market action.

–The predictive nature of the program becomes self-fulfilling. This happens to a lesser degree in the foreign currency markets already. Most of the traders we know in the FX market, and many of the systems, use Fibonacci retracements to establish lines of support and resistance for currency pairs. If everyone uses them, the Fibonacci numbers guide trading behaviour, at least until some external event comes along, which may change the status quo and require a recalibration of the trading program.

–You’d note that there’s a kernel of human judgement required in all this. A trading program is usually set up by a programmer. This person sets the rules for how the program can behave. But we are drifting to a world where programs can program themselves. When then happens, stock exchanges will either have become perfectly efficient (a sad day for Warren Buffett) or perfectly mad.

–Speaking of Buffett, he’s released his annual letter to shareholders. In it, he makes an observation that a computer might not. Buffett points out that there are three elements to how he and partner Charlie Munger determine the intrinsic value of a stock. The first is the value of a company’s investments, stock, bonds, and near-cash assets. The second element is the value of the non-insurance earnings generated by Berkshire’s holdings.

–The first two elements are objective. But the third is not. And that’s because the third element has to do with the future. As the future has not happened yet, you can’t measure it. So it requires a human being to make an informed judgement, partially based on past performance, with the obligatory understanding that past performance does not guarantee future results.

–Or, in Buffett’s own words:

There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.

This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings.

If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.

–Computers might be able to tell you when something is trading at a discount or a premium to its net asset value. But it takes a human being to really create that value. And some human beings do it better than others. A genuinely free market rewards entrepreneurs who consistently create value for shareholders and customers. Conversely, government is generally a value-subtracting exercise.

–Is there room for value investors in a market dominated by high-frequency trading and computers? We think so, which is why we agreed with Greg Canavan to publish his newsletter based on value investing principles. For example, in last week’s report, Greg surveyed four of Australia’s top energy producers to determine which represented the best value at this time. Part of his analysis included which company‘s managers routinely generate the highest returns on shareholder equity.

–We’d take Greg’s report over a computer any day, especially since he also bought us a beer at Barney Allen’s when visiting last week. How many computers will buy you a beer? Can your iPad buy you a beer? And how many investors are really looking at how a business’s managers are creating (or destroying) value on a quarter-by-quarter basis? Not many. You’d have an advantage.

–One last note on this. It could be that the IT architecture of the modern global trading system simply needs upgrading. If we are headed toward a convergence of trading platforms that allows for twenty-four hour trading of any security on any market from anywhere, it’s going to require a merging of exchanges and an upgrade of the hardware that allows for the volume and frequency of trading that would ensue.

–But do you ever wonder how long it will be before someone designs a trading algorithm that’s designed to manipulate the price of a stock? Can you imagine an algorithm that creates buying interest in a stock artificially? Meanwhile the programmer buys cheap out of the money puts on the share as his bot does its busy little work. Then, when the share price crashes, he cashes in.

–This reminds us of the story in Reminiscences of a Stock Operator where Jesse Livermore tells of how he liquidated a large insider position in a share by first buying the stock. Why buy it if he’d been hired to sell it? He had to create volume and price action that looked bullish. Buying up stock got the ball rolling…and then Livermore was able to feed his position back into the market one chunk a time, in non-suspicious amounts.

–By the time his inventory was exhausted, there were no more buyers and the insiders had sold out into a rising market. The buying interest collapsed and the share fell.

— This, arguably, is what the Fed has made possible for Wall Street to do in the last three years: use cheap short-term money borrowed from the Fed to generate trading profits in the market, suck the public back into equities, and liquidate the insider positions onto the retail investor. You’re left holding the bag. And there’s nothing in it but inflated claims on earnings that won’t show up.

–Now just imagine a bot designed to do the same thing to an index, or a share, or a currency. Now imagine dozens of bots doing the bidding of private corporations, foreign governments, rogue actors, or mal-contents who are excited about the prospect of hacking Microsoft’s share price into digital oblivion. Imagine a world full of high-frequency digital anarchists with the power to sabotage and destroy the regular workings of the world’s financial architecture.

–This is a kind of digital war of all against all that we may be headed to. It again shows the fragility of complex systems. And in a weird way, it shows how relatively static institutions are vulnerable to disparate, non-coordinated action from anonymous hackers on the Internet. But that is a subject for a different day!

–For now, Mineweb reports that Swiss commodities trading giant Glencore is thinking about going public.  This brings instant recall of Blackstone’s IPO just prior to the credit crisis in 2007. The kings of private equity sold their business to the public right before the credit depression dealt a powerful blow to their business model.

–If you can’t get rich by running your business, sell it to the public and get rich that way. When Glencore decides to sell its business to the public, does that mean there isn’t as much money to be made buying and selling commodities anymore? Is it a classic sign of a top in the resource market?

–Well, maybe it’s a sign that commodities might be going off the market altogether. When wheat and corn and fuel get too expensive, governments are bound to intervene with price controls and export quotas. The contest for a piece of scarce resources might shift from going to the highest bidder to going to the guy with the biggest gun.

–Have we reached the stage of U.S. dollar decline that price rises have made investing in commodities a lot less attractive? Is it going to be tempting to try and possess scarce resources outright through…other means? Well, Mineweb also reports that China’s foreign exchange head thinks that Chinese investment in commodities abroad will simply push up prices further.

–At what point does dollar devaluation get so swift that food and fuel are too expensive for some countries to buy on the open market? What happens then? More on that tomorrow….

Dan Denning
For Daily Reckoning Australia

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