Monday, August 22, 2011

Is the stock market going out of style?

With the economy in rough shape and uncertainty in the marketplace, it’s no wonder that individual investors are frustrated with the stock market these days. But if the stock market is going to be a reliable venue for growing and storing wealth over the long term, there are issues that go much deeper than the current economic climate that may need to be addressed.

Let’s look at the performance of the most widely known index, The DOW Industrials over the past 100 years. During that time the index has risen from around 100 points to around 10,000 points. That’s 100 times your money! Pretty good right? Actually, that’s just about a 4% annual rate of interest, before adjusting for inflation. If you could go back in time 100 years and invest $1,000, you might do just as well or better if you bought $1,000 worth of actual quality baskets rather than a basket of quality stocks.

Stocks had a momentus run between about 1985 and 1998. During that period, if you had bought at the lows and got out at the high, you’d have made a whopping 18% annual return. This was the advent of the internet age. All of a sudden information was cheap and easily obtainable. Commissions plummetted as internet trading houses like E-Trade and Ameritrade hit the scene. There was an explosion of individual investing. Prices soared, new companies took off like rockets. Then, of course, the bubble burst. It took a while for the individual investor to regain confidence and get back in the game, but back they came. Prices began to rise again. Then, of course, the housing bubble burst. Now, just three years later, the market is approaching 10,000 again. This time on the way down.

Not only are prices on the way down, but trading volume has actually been in a declining trend for the past two years. There’s good reason to be concerned. The very nature of the market has changed as much as the economy with the advancement of technology.

The vast majority of today’s trading volume is generated by computer programs called “quants” These programs make automatic, instantaneous transactions based on whatever data the programmers designed it to monitor. They look at trading data and try to find patterns. Some are even programmed to learn from their mistakes and make adjustments on the fly. Of course, much of that trading data is generated by other computer program trades. The result is that you have computer programs responding to the decisions of other computer programs. In the extreme you get situations like the “flash crash” of May 2010 when many large company’s stocks actually traded for $.01 (the exchanges later cancelled most of those trades). But how much does this type of trading effect stock prices when it’s not expressed in the extreme? The answer is nobody knows.

Stock prices are subjective. You can look at historical averages, but there is no price that any stock is “supposed to be” at on any given day or minute. These quant trades account for around 70% of daily volume. Most of the rest is day-trading, hedge funds and professional equities traders with outlooks of around 18 months. The traditional buy and hold investor, saving for retirement or school makes up just about 5% on any given day. The more computerized trading based on trading data takes place, the more divorced a company’s stock price becomes from any consideration of its business model or performance. Stocks go up because they go up and they go down because they go down. Moves in both directions are magnified as computerized triggers are set off. This is heaven for day traders, not so much for the passive investor.

I don’t believe the stock market is going to go away anymore than I believe lottery tickets or Las Vegas casinos are going to go away. But buying and holding equity in widely-held, publicly traded companies may not be a wise long-term investment strategy anymore. That’s not to say people wont make money. But predictability and connection to events on the ground is going out the window. Even a ban on computerized trading would only mean that you’d have to input the computer generated trade manually rather than automatically. You can’t put this genie back in the bottle.

Don’t take this as investment advice or a prediction of where the DOW is going to go in the future. But it is information you might want to consider and talk over with your investment advisor before deciding what to do with your hard earned savings.

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