Iron Capital Insights

  • Iron Capital Insights
  • September 21, 2011
  • Chuck Osborne

A Hidden Menace

John Maynard Keynes is known by most as a famous economist whose creative ideas on smoothing out the rough edges of the business cycle have proven repeatedly not to work. However, during his life he was also a money manager and one of the greatest of all time. His ideas on investing have influenced many, and some would argue that he invented the concept of the hedge fund. I tell you this because regardless of your thoughts about his economic ideas, I believe his thoughts regarding the market are worthwhile.

One of my favorite Keynes quotes goes as follows, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

It certainly feels like Keynes’ prophetic warning has come to pass.

The public markets have become hostages to so-called high-frequency trading (HFT) firms. These are organizations that trade stocks through computer programs at a rate of speed not before fathomed. It is literally possible for these firms to “own” a stock for no more than a few seconds. This is speculation run amok and they are harming our market, and as a result the allocation of capital in our society, and ultimately job creation and the economy as a whole. They need to be stopped.

It is important to understand why this is such a problem today. The stock market has always been home to a certain number of speculators; today they like to be called traders, but I prefer the more accurate title along with the deserved negative baggage. Having said that, speculators do serve a purpose, and they will always remind you of this. They provide liquidity. Long-term investors can buy and sell when they wish largely because there is always some short-term speculator willing to be on the other side of a transaction. Speculators can even provide opportunities for investors as they create dislocations in the market, beating up stocks to the point where they present great long-term opportunities for gain. Besides, speculating can be fun. We all have a little speculator in us. This is part of the lure of Wall Street to so many young professionals. (Experience usually takes away some of that luster; after all, Las Vegas was not built on gamblers’ ability to win.)

Historically, and not that long ago, speculators were held in check because theoretical profits of various rapid-trading strategies were destroyed in reality by taxes and transaction costs. This has changed. The automation of trading has made it so cheap that small profits can be made holding stocks for seconds. What this has done is ramp up the volatility to places I have never seen in my career. Much of it is just stupid.

One recent example can be found in the stock of Express Scripts. Express Scripts is a pharmaceutical benefits company – the people who pay for your prescription drugs. A well-known analyst lowered his price target on Express Scripts from $64 to $60, and the stock went down almost three percent that day. On the surface this may make sense – an analyst lowering the price target is not a good thing. However, the intrinsic fact being ignored is that Express Scripts was trading at approximately $43 when this announcement was made, so the analyst believes the stock is going to go up almost 50 percent. No human being would see that message as bad, but to a computer program that operates by a rule – analyst lowers target = sell – that is a different story. During the extremely volatile week of August 8, an estimated 80 percent of market volume was attributed to computer trading. The flash crash of last May was attributed to the same issues.

This volatility is keeping real investors out of the market. In fact I believe the old argument for speculators creating liquidity has fallen apart. By keeping investors away these HFT firms are actually destroying liquidity. Total volumes in the market are still below their 2007 highs.

The SEC is trying to do something about it. They are creating a trading auditing system named CAT that will help them monitor the actions of these HFT firms. The firms are pushing back. I don’t know if this auditing system will be the answer but it certainly will help. The added cost in trading alone will slow these firms down.

I have a better solution. Most of the money that floats around on our exchanges actually belongs to institutional investors – pension plans, endowments, foundations, and your retirement accounts. This money is all tax-exempt. In addition, hedge funds that consider themselves traders and not investors are given tax advantages. The bottom line is much of this extreme short-term speculation goes on because none of the practitioners have to factor in taxes. This means it makes no difference to them if their profits are from short-term trading or long-term investing. My suggestion is to take away the tax exemption for short-term capital gains for otherwise tax-exempt institutions. It wouldn’t take a week for every institutional investor in the country to pull every dime they have given to the short-term trading firms.

I am a big believer in free markets. It is usually the rules, not the freedom, that cause problems. In this case the rules – tax exemptions and tax breaks – have actually unintentionally encouraged speculation over investment. It is time to correct that. Creating an audit trail and/or paying a tax will not eliminate speculation, nor should it. It may, however, put it back in its place, as the bubble on the steady stream of enterprise.

The rapid-trading firms are a small, cohesive group with a lot of money, which gives them a great political advantage over the masses of investors who would benefit from their being constrained. I urge each and every recipient of this message to reach out to their elected officials and tell them you wish to encourage investment and discourage speculation. Remind them that capitalism is not about trading, it is about capital flowing to real companies that produce real products and in so doing, create real jobs.

Chuck Osborne, CFA
Managing Director