BNY's always informative and entertaining Nicholas Colas has a habit of seeing the silver lining, when others only see a putrid and radioactive mushroom cloud. And in this case, we do tend to agree with him... somewhat: when looking at the transformation currently gripping stock markets, instead of taking either extreme, Colas takes the Keith Richards path: adapt and survive (instead of fading away). And in surviving, the market may just return to that “old school” model of stock picking, and thus, fundamentally based stock trading, something which all investors and market participants lament and remember fondly as a bygone era before the Fed decided to take control of the entire capital market. However, where we are far less sanguine, is that for Colas' prediction to come true, it would necessarily (and sufficiently) require the removal of the Fed and its tentacular influence on stocks. And thus the question: can the existing stock market model survive an overhaul in which the underlying economic model reverts back from a central banking primed fiat system, to some "other" form of sound monetary decision making. That, we do not know.
From BNY ConvergEx:
Keith Richards and the "Death" of Stock Trading
Summary: U.S. equity volumes have been in decline since the volatile days of the 2008 financial crisis and October saw some of the slowest days of the year. That’s an outcome, we argue in today’s note, of the slow growth U.S. economy and monetary policies put in place to dampen economic volatility. Yes, segments of the market still create trading volumes higher than a few years ago – high frequency trading and exchange traded funds lead the charge here. But to reignite interest in fundamentally driven trading we’ll either need to see much better economic growth (unlikely) or a significant change in the way money managers operate. There’s plenty of opportunity on that front and such changes would also make for a better functioning capital market.
Back in 1973, the British music magazine New Music Express put Keith Richards on their annual list of “Rockers Most Likely to Die” in the next year. Keith (or “Keef”, as the British press and fans like to call him) remained on the list for ten years straight. During that time he did pretty much everything possible to make that prediction come true, but despite a decade’s epic consumption of heroin, acid, and alcohol as well as sleeping with a loaded pistol, Richards managed to stay above ground. NME eventually gave up and retired his name from consideration, which pretty much means that Keith Richards is immortal. That’s about right, in my book.
Lately it’s felt like U.S. equity trading might replace Keith Richards on that “Likely to Die Soon” list. Consider the following data points:
- Trading volumes in S&P 500 names run about 4.5 billion shares/week at the moment, down 10% from the typical rate in January 2010.
- Volumes during the early March 2009 lows were 7.5 billion/week for the same names, or 40% higher than current volumes.
- We are essentially back to early 2008 volume levels, but October saw some of the lowest volume days of the year. The trend is not the friend of trading volumes at the moment.
There are many root causes for this phenomenon. Here are a few of the major ones:
- The lurching volatility of the last three years must have pride of place, of course. Nothing scares away capital like mind numbing volatility.
- Sharing the spotlight is the long hangover of the tech stock bubble of the late 1990s, which took major stock indices to unsustainable levels. The S&P 500 is still some 22% below the levels reached in March 2000. Stocks stopped being the 8-11% annual return investment vehicle expected by a generation of market participants. That has encouraged capital of all stripes to look elsewhere for return, as I will touch on in a minute.
- All the recent talk of increased savings rates aside, the current period of domestic recession and jobless recovery does little to provide extra capital for investment. As we have noted in previous reports, October saw one of the lowest rates of tax/withholding receipts to the U.S. Treasury since the 2008 financial crisis. There just is not much “extra” money in consumers’ pockets to invest. The same goes for corporations with underfunded pension plans, where holding onto cash is the priority of the day.
- Alternative investments to U.S. stocks have performed better. Whether we’re talking about precious metals, rare sports cars, commodities or foreign stocks, investors are always going to be drawn to the “New Highs” list long before considering investments in lagging categories. U.S. stocks fit all too neatly into that latter category, aside from a few high profile technology, consumer and industrial names.
But, like Keith Richards, it is too soon to put U.S. stock trading on the endangered species list.
- First of all, part of the problem in considering the current volumes is simply a matter of where you want to start the clock. Yes, against the last two years volumes are down substantially. Measured against the first half of 2007, however, when S&P 500 volumes were closer to 3 billion shares/week the current rate is still respectably higher. If you happen to be a broker/dealer, you have felt the pain of price compression in commissions of course. But overall volumes aren’t that bad.
- There are, in fact, growth areas of stock trading over the past five years. There are 20% more exchange traded funds now then at the beginning of 2010, for example. ETF product development is an evergreen process, and I have no doubt that the number of ETFs on offer will double long before major stock indices do the same. After all, they have the flexibility to pursue investment opportunities across almost any asset class. As one famous market commentator likes to say, “There’s always a bull market somewhere,” and the ETF world will invariably create products to track them.
- Thanks to significant changes in market structure over the past decade, there many more places to trade stock than in the 1990s, generating large amounts of new volume. Yes, the NYSE and NASDAQ still exist, but there’s also BATS, Direct Edge, Liquidnet, and broker-owned dark pools. As the number of trading venues grows arithmetically, volume seems to expand logarithmically. One popular slam against the old exchange structure was that “Five guys named Vinnie” touched your trade as it made its way to the floor for execution, creating opportunities for information leakage. Now, there are more like 5,000 computers we’ll playfully call HAL constantly involved in 5,000 stocks simultaneously (one of which is the name you are trading). This dynamic has taken overall volumes from the 1-2 billion shares traded daily in the early 2000s to anywhere from 7-8 billion today.
Where things get more problematic is when you consider the future of “old school” single stock trading, where the investment decision to buy or sell is fundamentally based. It is worth remembering that capital markets have two functions:
- Incorporate all available knowledge about the fundamentals of an investment into a price for that security.
- Provide as much liquidity as possible for those who want to buy or sell so their orders don’t overly distort prices.
Changes to market structure in the last decade mean that liquidity now comes with lots of high frequency trading – up to 70% of all trades according to a variety of sources. At the same time it is hard to argue that HFT brings anything to the party on the other function of capital markets: fundamental price discovery. Even if there are fundamental inputs into certain HFT strategies – high speed reading of news headlines, for example – their seconds/minutes long holding periods don’t reflect any confidence that these decisions have lasting value.
To close out this note I will offer up a list of short list of factors I think will reignite interest in that “old school” model of stock picking and, by extension, fundamentally based stock trading.
- Accelerating economic growth. Stock picking is about finding stocks that will do better than their peers by a wide margin. This process justifies everything from active managers’ fees to the institutional allocation of capital to this strategy. The anemic growth we’ve seen in developed economies since the financial crisis doesn’t give as much of a tailwind to excellent companies as faster economic growth would engender. Most fundamental portfolio managers will tell you in moments of candor that much of their performance in good years stems from a few great ideas. Everything else tends to cancel out. The better the economic backdrop, the more chance for those big ideas to generate truly outsized returns.
- Less government involvement in the economy. Look at the financial sector for proof of this point. As wrenching as a deeper crisis in this industry might have been in 2008, it would have created a much more dynamic recovery than the “Too big to fail” policy has allowed. Government intervention of all types kept this from happening. The same goes for the current activist Federal Reserve policy of Quantitative Easing. Pumping hundreds of billions of dollars into a moribund economy while keeping interest rates at zero seems to maintain a tired status quo more than it offers better-run companies a chance to excel.
- Merger of HFT and fundamental strategies. The current U.S. market structure essentially features three types of players with almost nothing in common. In one camp are the indexers, who allocate capital to passive indexes such as the S&P 500. The second group is active managers, who employ fundamental analysis to find winning investment to buy and underperforming ones to short/underweight. Then there is high frequency trading, which dominates trading volumes but acts more like a market maker than investor.
There is nothing, aside from preexisting investment policies, preventing fundamental managers from incorporating HFT techniques into their own approaches to investment. The cost to trade U.S. equities has fallen close to zero, so trading around existing positions with HFT strategies is a viable area of incremental alpha to traditional managers. Yes, it will up their turnover dramatically, but that is a small price to pay for increased performance in a sluggish market.
Keith and the rest of The Rolling Stones are alive and touring today because they adapted. Fewer drugs, more antioxidants, and a savvy tax strategy (more on that in another note) all contributed to that success story. Better returns through creativity are a hallmark of capital markets as well. Traditional managers will adapt, since it is hard to see how the economic backdrop will change any time soon. Adapt, or as the Stones sang, “Fade away.”