How Traders Killed Value Investing

June 15, 2009 · Leave a Comment

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By David Weidner (WSJ)

Long before the June 1 negotiating deadline, it became quite clear that General Motors Corp. was headed for bankruptcy. Its debtholders were going to get crushed. The shareholders were wiped out.

Except that they weren’t. As the deadline neared, shares of GM did a funny thing: They kept trading at more than $1 each. They didn’t disappear.

Last month, shares rose a few pennies during a given trading day and fell a few pennies the next. Taken as a whole, GM shares reflected nearly $1 billion in value that did not exist. Even today, with GM in bankruptcy, the automaker’s shares are trading around $1.50.

Market analysts seem baffled, but trading in GM reflects the sea change that’s taken place in the markets during the last decade. Simply put, the market has slowly given itself to short-term traders. The traders control volume, and whoever controls the volume controls the price.

The old notion that profitable companies with good growth prospects should have rising share prices — and that failures like GM should be gone, or at least trading in the pennies — is history.

Today, a hedge fund investing billions using a quantitative formula can stall a stock; a couple hedge funds aligned can turn a profitable company into a Dow laggard. Toss in a few short sellers and you have the great Wall Street collapse of September 2008.

It wasn’t always this way. Before the machines and the shorts took over Wall Street, stocks were evaluated by an underlying company’s prospects. Buy-and-hold investing ruled the day. Investors such as Warren Buffett and Bill Miller were the models.

Those fellows are a far cry from this generation’s masters of the universe. Traders are in charge now. They rule the market. They dominate volume. That stock you bought because you thought the company was in good shape? It’s a pawn in the hands of a computer model or some supertrader like Steven Cohen at SAC Capital Partners or Bridgewater Associates’ Ray Dalio.

To move a security, they don’t need to own it. They can have a short position. They can put an order to sell 1 million shares in a dark pool, those anonymous marketplaces that operate outside the walls of the exchanges. They can own options or futures contracts. Buy enough GM puts and watch the price begin to fall under the pressure.

Stocks As Targets

For the long-term investor, whether you’re investing for retirement or simply betting on a company’s potential success, the payoff is suddenly in play — every stock is a potential target of forces outside of the traditional movers.

The buy-and-hold guys are still there, but lately they’ve been less successful than their hedge-fund counterparts.

Mr. Buffett and Mr. Miller ride the wave of the overall market, hoping that their undervalued holdings will someday be valued by investors. The hedge fund guys create their own wave. Mr. Buffett is slow and deliberate with his investments, usually holding stakes for years. By comparison, Mr. Miller is a speed demon. He turns over 20% of his portfolio every year.

Quants, hedge funds and today’s new breed of trader can turn over their holdings in a day or even just a few hours.

Slowpokes like Mr. Buffett and Mr. Miller don’t bring Wall Street enough fees for the brokerages to care about them. For all the success markets and regulators have had in slashing trading costs, those reforms have inadvertently hurt small investors.

Mr. Cohen and Mr. Dalio are exactly the kind of customer Wall Street cares about. You and the guy who runs your retirement portfolio couldn’t provide enough fees to buy a dinner and drinks at Dylan Prime for the prime brokerage trading desk, much less a Bentley. The brokers just want to handle the action and they don’t care what kind of order you place: long, short, puts or calls.

As spreads on the exchange have shrunk, trading margins squeezed middlemen on every transaction. The best way to offset those losses has been to increase the number of transactions. Brokers have been happy to step up to heavy traders such as hedge funds and provide margin loans. Those loans not only increase volume, but carry more lucrative fees.

The special attention paid to big traders doesn’t only distort the market, it leaves fewer resources for investors with longer time horizons. During the last year, about 2,000 sell-side research analysts — the guys paid to inform investors — have exited the business, according to an earlier report in The Wall Street Journal.

And why not, when machines make so many of the day’s trades?

Wagging The Dog

Program trading, which mechanizes a variety of trading strategies, accounted for about 30% of volume on the New York Stock Exchange in May, compared to 10% a decade ago. It was just 4.6% for the same month in 1989. The NYSE cautions that its methodology for counting program trades has changed over the years, but you can see the trend.

A 2007 study by the consulting firm Greenwich Associates found that the credit derivatives market — the vast network of agreements and contracts that bet on debt — now drives the pricing of the corporate bonds that underlie those derivatives, a development akin to the rabbit chasing the hound.

Money managers have complained this trend is making corporate bond prices more volatile. The study concludes: “In many ways, hedge funds have become the market.”

A market dominated by nontraditional trading forces explains, in part, why GM shares have kept so much value. Arbitrage traders make a lot of contrarian moves. They buy to cover their short positions. They sell to take a profit. All they really need is for the price to move.

There’s no simple solution to the problems of the market. A few proposals today aim to improve things a bit, such as the elimination of naked shorting, reinstatement of the uptick rule and more transparency of traders’ holdings. Some people, like Grant Thornton’s David Weild are calling for separate markets for certain securities, such as newly issued stock.

But separating investors from traders in the market would destroy it. The market needs both. Traders, after all, provide regular price discovery and the other side of the deal. They keep the market moving, but they’ve also replaced investors as the market’s driving force. Don’t bet on that changing anytime soon.

Categories: News
Tagged: buffett, hedge funds, trading, Value Investing

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