Third Quarter 2011 Perspectives Newsletter
Where Have the Investors Gone?
Marian Kessler
The Efficient Market Hypothesis, crafted by economist Eugene Fama decades ago, and widely embraced by investors and academics, argues the stock market rapidly digests and discounts all information available to the public, simultaneously and democratically. The theory asserts that the price and valuation of each stock, at any given moment, accurately and immediately reflects investor perception of current and expected events. EMH reached its height of popularity in the 1980s, a decade interestingly characterized by an increasing amount of self-serving and occasional criminal behavior, including trading on inside information, clubby debt deals and market manipulation. Perhaps the popularity of efficient market/”random walk” theories was a need on the part of investors to trust in an impartial financial system—markets that were equitable and impervious to the behavior of individual market participants. The gradual disenchantment with efficient markets, set in motion thirty years ago, continues to this day, as an increasing percentage of the population feels financial markets are rigged to benefit a small percentage of insiders. The Occupy Wall Street movement and Billionaire Tours indicate an increasing backlash against the power elite and extremely wealthy.
In today’s world, the concept of efficient, dispassionate and impartial markets seems almost quaint. The notion that all information is available to all market participants in the same depth and at the same moment seems absurd. Seeking an edge by trading on good old-fashioned inside information still exists, but attaining that competitive advantage within the letter of the law is safer, and probably easier, than it used to be. It has been suggested that corporate America and Wall Street have used opportunities created by changes in monetary and public policy to benefit their own immediate interests. Lobbying efforts by banks and others may have unduly swayed policymakers to impose more muted reforms than initially recommended. And numerous investment companies have spent tens of millions of dollars on sophisticated computer systems located in close proximity to exchanges, designed to generate revenue through sheer transaction volume rather than positive spread. This so-called “high frequency trading” (HFT) was originally designed to provide competition among security trading exchanges and increase trading liquidity. It is now a significant revenue source for the exchanges and a handful of trading firms competing to shave microseconds off a trade. This is not investing. It’s not even speculation. It’s algorithms that front-run customer orders - designed to create, capitalize and increase market volatility and ultimately undermine confidence in the markets.
Confidence in our political and economic infrastructure has eroded sharply since the financial meltdown in 2008. Unemployment remains high, possible global sovereign debt insolvencies weigh heavily on financial markets and political impasses are thwarting regulatory reform, tax policy and entitlement spending changes. Recent stock market behavior reflects this political and economic polarization. It often feels as if we were at a standstill, with markets gyrating wildly on rumor and grandstanding. In the next few years, the most likely government and regulatory responses are likely to include:
- Tax increases: A 5% surtax on those individuals earning in excess of $1M annually is gaining momentum with the current administration, as it seeks ways of funding economic stimulus, jobs and health care programs. Although its passage is uncertain, a trend toward higher individual tax rates is gaining traction. The direction of corporate tax rates is a bit more uncertain. However, federal taxes currently represent 17% of GDP, below the historic average of 18.5%. The Simpson-Bowles balanced budget proposals include increasing overall taxes to 21% of GDP. Other suggestions include $3 of spending cuts for every $1 of tax hikes, a haircut to all tax deductions, including mortgage interest, and increasing the tax rate on capital gains and dividends. Tax hikes seem inevitable to support burgeoning social obligations. Interestingly, other than Republican Herman Cain’s 9-9-9 plan, the subject of a flat tax with income breakpoints remains off the radar of mainstream politics.
- Federal government spending cuts: Government spending has ballooned to 25.5% of GDP from a post WWII norm of 19.6%, according to Ned Davis Research. Curtailment in entitlement and other federal programs seems inevitable. Discussions include extending retirement benefit age, raising cap rates, reducing “promised” benefits to social security, Medicare or Medicaid recipients and increasing the Medicare payroll tax. Tax and entitlement benefits reform are enormously difficult, divisive issues that must be dealt with by a functional government. Populist rhetoric from both parties – proposing legislation that has little or no chance of passing in order to make the “other side” look unscrupulous – seems to be the norm these days, as reelection has become the imperative.
- Implementation of effective financial reform: This does not include something as meaningless as reducing “swipe” fees on debit cards. It means limiting the ability of financial institutions to use “their own” capital to trade stocks, bonds and derivatives. It means requiring banks to keep more capital, limiting use of leverage and tiering capital according to asset risk. The Volcker Rule, currently in the drafting phase, calls for increases in internal compliance and oversight by regulators. Large firms could be required to provide regulators with over 20 separate metrics of investment activity each month to prove they are adhering to regulation. Some financial participants have stated that the competitive disadvantage generated by restrictive reform measures could erode the dominance of US financial markets and allow offshore banks to get the upper hand. As history indicates though, financial license often ends in disaster.
While we are on the topic of financial reform, one area of risk and abuse seems like an easy and obvious fix – place fees on high-frequency trading. Not long ago, stock exchanges were filled with gesticulating and raucous traders, aligning orders of equity buyers and sellers. But in the mid 1990’s, legislation was passed to allow for the creation of numerous stock exchanges to compete with the NYSE and others, thereby driving down trading costs to clients and increasing market liquidity. These HFT firms are paid a very small fee per trade for their service, thereby turning a profit, regardless of the profitability of the trade. Today, an estimated 75% of daily market volume is generated by high-frequency trading systems, powered by increasingly complex algorithms, primarily trading with other algorithms.
Markets have evolved beyond the alignment of market participant interests. “Investment” companies are placing their multi-million dollar computers in as close proximity to exchanges or building fiber optic cables cross-country (or cross ocean) to shave microseconds off the speed of a trade – 40x faster than the time it takes to click a mouse. For example, last year the NYSE moved its computer infrastructure to a facility it built in New Jersey, where it leases space to trading firms. The Exchange commands premium prices on its leases because close physical proximity means faster access to the Exchange’s raw trading data. Most other market participants don’t see that data until microseconds later, after it has been combined with information from other exchanges. In addition, these “trades” often appear to have nothing to do with buying and selling stocks. In many cases, there is never any intent to facilitate an actual trade. The result is amplified daily market volatility, non-fundamental and often violent movements in individual stocks and the increased potential for “flash crashes”, like in May 2010 which was believed to have been caused by rogue algorithms.
There are numerous fairly simple solutions to curbing HFT, including assessing trading fees, reviewing HFT codes, increasing reporting requirements or restricting access to proprietary data. HFT is clear exploitation and its diminishment would go a long way to restore traditional investor confidence in financial markets. Rebuilding financial, political and economic confidence can only be accomplished by removing elitism - the conviction that policy is not employed to benefit a few, at the expense of the majority.
Becker Value Equity Fund
★★★★ Overall Morningstar Rating™ Out of 1,114 Large Cap Value Funds
The Total Gross Expense Ratio of the Fund as disclosed in the most recent prospectus is 1.10% and the net expense ratio after contractual fee waivers is 0.94%. The advisor has contracted with the Fund through 2/28/13 to cap certain operating expenses at 0.93% plus Fees and Expenses of Acquired Funds of 0.01%.
Peer Ranking
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