The End Of 'Orderly And Fair Markets'

Tyler Durden's picture

Capitalism may have bested communism a few decades ago, but exactly how our economic system allocates society’s scarce resources is now undergoing its first serious transformation since the NYSE’s founding fathers met under the buttonwood tree in 1792.  Technology, complexity and speed have already transformed how stocks trade; but As ConvergEx's Nick Colas notes, the real question now is what role these forces will play in long-term capital formation and allocation.  Rookie mistakes like the Twitter hack flash crash might be easy to deride, but make no mistake, Colas reminds us: the changes that started with high frequency and algorithmic trading are just the first step to an entirely different process of determining stock prices.  The only serious challenge this metamorphosis will likely face is a notable crash of the still-developing system and resultant regulation back to more strictly human-based processes.


Via Nick Colas, ConvergEx,

Last week’s Twitter hack and resultant mini-crash in U.S. stocks made for a few minutes of confusion and several days of humorous commentary.  It is, however, also a sign of the times.  That a system of communication where Justin Bieber, Lady Gaga and Katy Perry are the lead dogs could encroach on “Orderly and fair markets” should force some discussion of where U.S. stock markets are heading.  “I crashed the market and I liked it…” isn’t a top 40 song. Yet…

Let’s begin with a few basics about what role equity markets are supposed to play in a modern capitalist economic system:

  • Stock markets exist to determine the value of publicly held companies using all legally available information that may impact their future cash flows and strategic positions.  There are a lot of items on this menu of value drivers, from prevailing interest rates to the quality of a given management team.  The benefits to any individual or group of investors to predicting enough of these inputs correctly on a consistent basis are, of course, sizable.
  • The resulting prices are signals to the broader economic system about the ongoing value of the company’s business model.  Well-considered companies with high valuations can purchase the assets of laggard enterprises with low valuations and operate them better.  Poorly run businesses fail, freeing up society’s intellectual and physical capital to pursue better uses.  Private equity can purchase underperforming assets as well, hopefully to re-engineer the business and return some or all of it to better health.
  • Through the IPO process, equity markets allow promising enterprises to tap a large pool of capital that allows for further growth.  Once public, they can make acquisitions for stock and reward productive employees with real ownership in the business.
  • Stock grants to management in well-run businesses – old and new - can allow the operation to entice the best available intellectual capital to join the firm and maximize their focus while employed there.  This ideally allows society to ensure that the scarcest of all economic resources – people – flow to their best possible uses.
  • Stock prices provide valuable economic signals to society at large – labor, capital, government and all other economic actors.  This, by the way, is why the Federal Reserve and other central banks care so much about rising equity values.
  • Public ownership of private capital allows society to “Spread the wealth around” through the individual ownership of equity assets.  Individuals can buy diversified portfolios of public companies and earn returns on their capital that mirror the trends in return on investment capital for the businesses they own.
  • Yes, I know it’s fashionable to pick apart these idealistic characteristics at the moment.  At the same time, free market capitalism has a reasonable track record over history for improving the lives of large chunks of the human race.  So until we get a race of incorruptible philosopher-kings in the mix, this structure is the best thing going.

The Twitter hack is the most notable example of “How” this process has changed, specifically in the real-time valuation of U.S. stocks.  To understand where we are, you first need to parse out the important changes that have occurred in stock trading over the last +10 years.  Over that period, market structure moved from having one dominant exchange for a given stock (IBM on the New York Stock Exchange, Microsoft on the NASDAQ) to a highly fragmented system of multiple “exchanges” – pools of buy and sell orders managed by very fast computers.

Technology – very fast, efficient, even ruthless – is therefore the backbone of the modern U.S. equity market.  It should be no surprise that this development is not without controversy.  The multitude of trading venues takes some pretty amazing processing horsepower to keep in sync.  The computer code needed to arbitrage prices among them needs to be highly efficient and operate faster than a human can literally blink an eye.  And the physical plant – cutting edge servers located near the data centers for the major exchanges, connected by microwave or high-speed data lines – costs billions to build and maintain.

With all this infrastructure in place, the logical question is “What’s next?”  To answer that larger question, we need some additional context:

Point #1: Human based active equity management has had a tough slog since the Financial Crisis, especially as it relates to U.S. stocks.  Money flows out of domestic equity mutual number in the hundreds of billions, and there hasn’t been a three-month period for positive flows in years.  That’s a significant development because this base of assets historically funded much of Wall Street’s traditional single-stock research efforts.  Sell-side analysts still have their role, to be sure, but over the last decade the job has been more of a concierge for management meetings and conferences than single-source experts on the investment merits of individual stocks.

Hedge funds do still gather assets, but their investment process values internal resources and evaluation over traditional broker-supplied research.  This group is the primary customer for newer products, ranging from satellite imagery of store parking lots to cyber-tracking of online web companies’ traffic patterns.  They also have the luxury of focusing their efforts on just a few investment ideas rather than needing to cover the entire investment waterfront.

Point #2: Passive management of U.S. equity assets continues to grow in popularity.  Nowhere is this more visible than in the ever increasing asset base of U.S. listed exchange traded funds, where $39 billion of the total year-to-date ETF money flows of $65 billion have gone straight into domestic equities.  The single most popular deomstic stock ETF by this measure is a relative newcomer: the iShares MSCI Minimum Volatility Index Fund, which only launched in October 2011.  The investment goal for the index underpinning this product is to provide equity returns in the context low overall price volatility.  Everything is done with mathematical analysis, rather than having a team of human analysts make stock-by-stock evaluations of potential investments with the help of Wall Street research.  That’s a very different approach from the old-school methods of managing money anchored in human judgment, to be sure.  How this approach does over time is anyone’s guess.  But it is a useful signpost for how money management as a business is changing.

Point #3: We work with a variety of quantitatively based investment managers at ConvergEx, and their appetite for research skews strongly to datasets and real-time indicators of business fundamentals.  In an increasingly open world, and thanks to our ever-increasing reliance on technology, there is no shortage of new resources to feed a numbers-based investment discipline.

A few examples serve to highlight this growing field.

  • One research provider I know has permitted access to the contents of hundreds of thousands of individual email accounts.  Any personal identifiers are stripped out before they get the data, but what’s left is a very useful amalgam of information about buying trends for everything from online retailers to video content providers.
  • Another product we’ve seen recently offers up essentially real-time satellite imagery of retail store parking lots around the country.  Forget walking the mall; you can count cars parked next to 200 representative stores for your favorite retailer. And if U.S. retail is too prosaic, they can get you images of virtually any place on the planet, cloud cover permitting. 
  • Lastly, one product which has been out for several years scours the websites of every airline around the world to see how much these businesses are charging for tickets and how full the flights are getting.  It’s not a perfect source of information – you need a handle on cost structures to know earnings – but it is a great starting point to understand near term business fundamentals for a very volatile sector.

The upshot here is that the technology of market structure – large, expensive and complex – is looking for a dance partner and our increasingly tech-based society is increasingly able to play that role.  The critical questions to this inevitable direction are pretty straightforward:

  • Can anything change this glide path to an ever more technology-based system of stock analysis?  I can only think of one: a very large system failure that causes a recession in the U.S.  We’ve seen individual brokerage firms teeter on the brink of failure after a systems glitch caused a large trading loss.  The momentum behind the current migration to technology-based data analysis in order to assess stock prices is strong.  At this point, only regulation can likely reverse it.  And regulation in the U.S. only comes after large systemic failures – never before.
  • How will capital markets assess stock prices in 5, 10 or 20 years?  There’s a saying in the tech world, especially among hackers: “Information wants to be free.”  On Wall Street, information is supposed to be expensive, since it can be used to generate profits.  Now that technology is being used to generate fundamental insights into corporate performance and the direction of stocks, which approach will win?
  • Over the next decade, as investors in U.S. stocks continue to expand their use of datasets and online resources to analyze securities, information will likely continue to be expensive.  We’re still in the early days of this transition, after all.  Thousands of institutional investors still use analyst-based resources and personal judgment to allocate capital and this process isn’t going away.  Many are adapting as the world changes, offering up new sources of investment insight through an effective hybrid approach. 
  • Over the long term – and I am talking decades here – it does seem inevitable that the analytical function behind assessing stock prices will change dramatically.  Will equity research based solely on human judgment go the way of the neighborhood bookstore, a quaint anachronism in an ever more connected world?  I can’t help but think that the answer is “Probably.”

Will capital markets become more efficient as a result?  If computerized algorithms with access to petabytes of real-time fundamental data can perform single stock analysis efficiently and without human biases, shouldn’t we welcome the development?  Stock market volatility might diminish with all that finely parsed data, and capital markets could become more accurately predictive of future corporate profits and strategic outcomes.

At the same time, technology has a way of creating distance between humans just as much as it can bring them together.  Just ask any parent with a college-aged child for the ratio of text messages to actual phone calls from their offspring.  Will an equity market running on algorithmic autopilot serve to tie the managers of capital (senior executives) to the ultimate owners (shareholders) as robustly as one dominated by flesh-and-blood money managers?  It seems a stretch to think so.

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redpill's picture


espirit's picture

This pretty much goes along with Bloomturds Declaration of Servitude, and re-interpretation of the Bill of Debts.

Herd Redirection Committee's picture

OK, so you are going to let algos and computers decide what companies stock to buy... How long until companies know what the algos are looking for, and give it to them, i.e. you have the accountants cook the books to show certain ratios, pull the old Enron trick of classifying expenses as assets and Bob's your Uncle.

screw face's picture

accountants.............Enron.................Toast on a Stick

Groundhog Day's picture

I was doing so well on the roulette table until a HFT program ran wild and just started rolling 0 / 00

nmewn's picture

A Bit-Market, what could possibly go wrong? ;-)

Jekyll_n_Hyde_Island's picture

No one in Washington is smart enough to understand what rollercoaster algo profits are, much less draft and implement any legistlation to prevent the devaluation of equities.  Odds are some fucking idiot, (most likely subscribing to the ass party) or group of idiots will get together like Dodd-Frank and publish some regulation that actually fuels more pseudo-valued algo engines.


  Just more proof that hard commodities like Platinum will retain and grow in value.  You can fuck with the paper and the futures, but you can't fuck with the phsycial product.


ParkAveFlasher's picture

They know enough about HFT to vote themselves legally pre-market information.

I practice Hanlon's Razor in reverse.

Hanlon's Razor: Don't blame evil for what is clearly explained by stupidity.

The reverse: Don't blame stupidity for what is clearly explained by evil.

Jekyll_n_Hyde_Island's picture

  I'm wondering how much puppeteering was in that bill.  There are these dark shadowy masses much like those cast by the fire in Plato's cave that I'm sure are behind this.  I'm just not willing to chalk it up to the Jews.

ParkAveFlasher's picture


If you don't price trade in gold, and especially if gold never crosses borders, you must have local currencies and their attendant arbitrageurs (sp).  The institutions of credit that all trade implies become more vital in such a system of credit scrip, and may become swollen as trade volume swells, as it is predisposed to do when the currency itself can blow on the wind. However the job of agreement of terms has to still be achieved.  Metallic systems are easy enough to agree upon: you price your goods in a verifiably pure amount of the metal and change hands.  Fiat systems, not so much.  Risk implies interest, which implies expansion, which implies inflation, which implies more risk of value distortion, as your baselines are exploded in every direction.

HFT is designed to absorb shocks (you might think of it as a "shtawk absorber") and "disburse" the potentially de-stabilizing forces throughout the entire framework of global finance.  HFT is required today precisely because inflationary forces introduce degrees of volatility that markets run by humans and their cumbersome humanity could not participate in, much less operate, much less profit from.

Banks need prop trading desks because they price their existence in this volatile compound called fiat, and buy and sell nothing of tangible value.  Time, they buy and sell time.

I digress...

It is very easily postulated that insular communities with a far-flung diaspora concentrated in the world's urban centers - the national cores of finance, government, and commerce - may achieve a goal of monopolizing trade by seizing financial choke points in these urban centers: the issuance of credit, the valuation and trade of scrip, the survey of contract laws and the dispensing of justice, and the geographic flow of credit and scrip.  This community would have to be hierarchal, strict, obscure, easily camoflauged, rabidly loyal, and with significant history built behind it with the correspondingly long-visioned historical resources and scholarly traditions.

Now, who does that sound like to you?

slaughterer's picture

Tomorrow: EOM window dressing (we go up and break ES 1600), then 1 May low volume anf FOMC (we go up), then Thursday (ECB) we still go up.  Then maybe Friday we go down.  

Kirk2NCC1701's picture

Paging Mister Ragnar Lothbrook and Mr. Hulk to Skynet Central. A slash & smash activity required.

JustObserving's picture

Fair and orderly markets were destroyed when the uptick rule was rescinded on July 6, 2007 after being in existence since 1938.

Groundhog Day's picture

impressive that you know the date

Timmay's picture

It's only a matter of time before this bitch realizes it is connected to, and controls; everything.

Manthong's picture

"tough slog"

not yet,, but eventually, and way more than tough.

otto skorzeny's picture

at the rate the Ponzi is going there will be no "stock prices to assess in 5,10 or 20 years". the only assessment in a few years will be if you are "fit for work" at the FEMA camp.

El Oregonian's picture

BERNANKE: "Was that assess or assist?"

prains's picture

80's = S&L scamathon

90's = Enron Accounting Scamathon

00's = Tech Scamathon 2000

10's = Mortgage Scamathon 2000.2


when did we have fair and orderly markets again? 

50's false war scamathon

60's false war scamathon 2.0

70's Nixon blows himself up

LawsofPhysics's picture

At least people went to fucking jail in the pre-2000's scam-a-thons.  Full regulatory and judicial capture now bitchez.

prains's picture

they built themselves some financial weapons of mass destruction so if anybody even looks sideways at them they go " uh ha" and put their finger on the button. yahtzee bitchez !

Poor Grogman's picture

What you mean there will be coffee machines, computers and email at the FEMA camps? I do hope it's decent stuff or that would really suck...

Cognitive Dissonance's picture

Markets do not move. They are more than ever.

DavidC's picture

Absolutely spot on, CD.


eclectic syncretist's picture

The apogee may be nearer than we realize


NoDebt's picture

I read an article this morning about a few smaller markets that are thinking about introducing random multi-millisecond delays or even "small batch and randmoize execution order".  Obviously, with an eye towards snuffing HFT's tactics.  I suspect they are trying to carve out a niche for themselves by being an ANTI-HFT market while every other exchange is, obviously, very much PRO-HFT.

Sounded like an elegant way of scuttling HFT without introducing any significant delay or added cost in actual order execution.


css1971's picture

Just don't let them cancel trades.

"You are now the proud owner of 90% of Netflix. How would you like to pay?"

Cacete de Ouro's picture

why does the travelgirls advert always appear after lunch?   gold diggas work on a full stomach?

espirit's picture

I always get Albanian Hooker ads after lunch.

ParkAveFlasher's picture

Albanian?  I get all flavors of Asian, with cool baseball card-stats like "mass in kilograms".

espirit's picture

Yes, with captions that say "wanna get weighed?"

piliage's picture

Like anything being bought now has any basis in fundamentals...Let's turn off the 85 billion a month and see some REAL price discovery. Woohooo!

Law97's picture

They're not even trying to say this rally has anything to do with anything else but QE. 


The MSM story today is "The recent spate of unexpectedly weak macro and earnings news has cheered stock investors who now believe the Fed must continue its loose monetary policy."


Litterally that is what they are saying today.  Go read CNBC et al and prepare to enter Wonderland. 

Poor Grogman's picture

They still can't bring themselves to substitute "ALGO" for "investor"

web bot's picture

They're #ucking absurd. Qemorphine and an impending cut in the European rate are the drivers. Full stop.

I can't imagine how I would be taught corporate finance today, compared to when I was in BSchool.


Widowmaker's picture

Who needs corporate finance with FASB 157.  It's the only thing you need to know.

q99x2's picture

Drop the dogs off at the kennel.

Widowmaker's picture

Tyler pushing propaganda describing the current racket as a "market."

These aren't markets, they are shit on a stick that Americans swallow as cotton candy until told to taste.


observer007's picture

Casey: All Banks Are Bankrupt


The whole banking business is corrupt from top to bottom today. Part of the problem is that banks are no longer financed by the individuals who start them, putting their personal net worth on the line. Now, they are all publicly traded entities - just like all brokerages - playing with Other People's Money. Management has no incentive to do anything but pad their wallets, so they pay themselves gigantic salaries and bonuses, and give themselves options. These people aren't shepherding their money and that of clients they know personally. They've got zero skin in the game.

Widowmaker's picture

Don't forget the first line item paid out of TARP was trader payroll.

That single decesion shreaded any last semblance of credibility for the entire fucking racket for a generation.

Second verse same as the first.

syntaxterror's picture

Capitalism bested Communism? Really? Tell that to the Chinese! Seems as if they have our jobs, factories, technology, and cash!

Ness.'s picture

Yet another catalyst for a new high... Russian Govt. confirms a rocket was fired at a passanger plane... stawks ramp higher on the news.  10 year UST unchanged - DOW up 121 and rising.  Nothing to see here.

fonzannoon's picture

Dow 15k (almost)

S&P 1600

Ten Year 1.67%

I can only guess that the insiders on the list got notified of QE6

yogibear's picture

And so on to QE to infinity. The Fed cannot stop buying up US debt with magic money.

Fuku Ben's picture

The market is just one giant wholly fraudulent illusory game of monopoly played on the backs of slaves

The winner with all the marbles has already been selected

Hint: Their einsatzgruppe begins with a Z