Tuesday, January 4, 2011

License to Steal?

A senior pension fund manager sent me a link to a Washington Examiner blog entry, Europe starts confiscating private pension funds:

The U.S. isn't the only place that's facing a major pension fund crisis. The Christian Science Monitor has this alarming report:

People’s retirement savings are a convenient source of revenue for governments that don’t want to reduce spending or make privatizations. As most pension schemes in Europe are organised by the state, European ministers of finance have a facilitated access to the savings accumulated there, and it is only logical that they try to get a hold of this money for their own ends. In recent weeks I have noted five such attempts: Three situations concern private personal savings; two others refer to national funds.

The most striking example is Hungary, where last month the government made the citizens an offer they could not refuse. They could either remit their individual retirement savings to the state, or lose the right to the basic state pension (but still have an obligation to pay contributions for it). In this extortionate way, the government wants to gain control over $14bn of individual retirement savings.

The article goes on to detail other pension grabs in Bulgaria, Poland, France and Ireland. Obviously, this is a cautionary tale for America. If fiscal austerity becomes a real issue in the U.S. the way that it's been reaching critical mass in Europe -- don't think that U.S. lawmakers regard your either your personal wealth or money they might owe you as sacrosanct. Government has a habit of looking out for itself.

While some governments are "Hungary for pensions", I wouldn't worry too much about a big US pension grab -- at least not yet. I am more worried about legalized theft taking place in the markets every single day. Yahoo Finance posted a CNBC article, Investing Dying as Computer Trading, ETFs & Dark Pools Proliferate:

There's an old Wall Street adage meant to inspire investors that goes "it's not a stock market, but a market of stocks." Consider that dead.

Computer trading, dark pools and exchange-traded funds are dominating market action on a daily basis, statistics show, killing the buy and hold philosophy still attempted by many professional and retail investors alike. Everything moves up or down together at a speed faster than which a normal person can react, traders said.

High frequency trading accounts for 70 percent of market volume on a daily basis, according to several traders' estimates. The average holding period for U.S. stocks is now just 2.8 months, according to the Crosscurrents newsletter. In the 1980s, it was two years.

"The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

The problem is only made worst by the proliferation of exchange-traded funds, traders said. The vehicles, which make trading a group of stocks as easy as buying and selling an individual security, passed the $1 trillion in assets mark at the end of last year, according to BlackRock. This is probably why all ten sectors of the S&P 500 finished in the black for two consecutive years, something that's only happened one other time since 1960, according to Bespoke Investment Group.

"The capital raising stock market of the past hundred years has morphed in just the last 10 years into a casino," said Sal Arnuk of Themis Trading and a market infrastructure expert who advised the SEC after last year's so-called Flash Crash. "Who is doing the fundamental work analyzing stocks? In the end, we've greatly increased systemic risk."

Another factor jumped into the fray in December: dark pools. Off-exchange trading accounted for more than a third of the trading volume in December, says Raymond James. While these trades are eventually reported to the public markets, they further damage price discovery, an essential element for a fair securities market, investors said.

"This was a record high market share for off-exchange trading and we believe the SEC will ultimately be forced to react to support the price discovery process by limiting off-exchange trading for all traces except for large block trades," wrote Raymond James analyst Patrick O'Shaughnessy in a note to clients yesterday.

"This destroys capital markets," said Jon Najarian, co-founder of TradeMonster and a 'Fast Money' trader. "Hidden trading venues, where some participants get to peek at the orders as they are entered so long as they agree to 'interact' with a minimum percentage, is not an exchange, it's a license to steal."

While many see these forces aligning to cause a sort of self-correcting powerful drop in the market down the road, others feel like it's creating an opportunity for the stock pickers to mount a comeback.

At the end of last year, something strange happened. After tracking the S&P 500 for most of 2010, the Russell 2000 Index, made up of many small companies with very different characteristics and merits, broke away in the final three months to double the gains of large cap benchmark for the year.

"Small cap outperformance in the last quarter is a very good sign this trend is ending," said Joshua Brown, money manager and author of The Reformed Broker blog. "Winners and losers are starting to separate themselves after a year of the whole risk-on (buy anything), risk off (sell everything) of the last year."

Of course, you could have just bought the iShares Russell 200 Index ETF (NYSEArca:IWM - News) in September.

I also feel that all these dark pools, ETF flows, and high frequency trading platforms are wreaking havoc on the market, but they do present opportunities for stock pickers. This is because if things get really out of whack, long-term investors (like pension funds) will move in, and in extreme cases, they may even take a company private.

Nonetheless, the reality is that investors are struggling to make sense of wild market gyrations caused by high frequency trading and dark pools. Over at Zero Hedge, they have been writing on this subject for a long time, but only now is mainstream media waking up to the fact that markets are routinely being manipulated by a few large and powerful players in this space. Some will dismiss this as "part of the liquidity game", but I think large pension funds should also be asking some tough questions on how these new "sophisticated" trading methods impact their holdings.

For me, this is all a license to steal. Sure, it's legal, but it's still theft using multimillion dollar computers that are able to trade faster than the speed of light. And I'm not so sure that the CNBC article got it right. I think Michael Hudson got it right, the average stock is held for 22 seconds and foreign currency investment for 30 seconds. As sad as this sounds, this is the reality of our "new and improved" markets. Computers have taken over, and while there are limits to these trading platforms, they are increasingly dominating the way markets react to fundamental news.

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