The Most Serious Affliction of our System: Outside Trading

As part of the hypertrophy of finance I described in the Scandal of Money and Life After Google, the bots are taking over the capital markets.

More than half of all the activity in current stock markets is algorithmic trading done by computers rather than investment done by humans.

Much of the rest comprise buybacks by companies of their own shares.

Index funds, exchange traded funds, and most derivatives belong in casinos not in serious portfolios. They have nothing to do with real investment in companies. Their successes come from front running and fast trading rather than insight or foresight.

By instantly spreading information, the internet was supposed to be a remedy for robotic investment, bringing more data on more companies and more securities more cheaply than ever before. So why in the midst of the information age, when capital and data zip around the globe at the speed of light, do markets behave like the tulip auctions of 1690, when the fastest transmitters were carrier pigeons?

The reason is what I call the “outsider trading scandal.”

Volatility in the Markets

I am currently deep in my new monthly report in The George Gilder Report, presenting a new company for my subscribers. So, I will let my argument be trenchantly completed by my longtime investment partner Gerard Frigon, of Taylor Frigon Partners in Paso Robles, California. Below, in his report, Gerry tells why the markets are so volatile:

“If anyone really enjoys the kind of wild swings in individual stocks that make no fundamental sense (and, for that matter, swings in the major stock market averages) … then they should just keep proliferating the “derivative” phenomenon of passive vehicles like ETFs and the algorithmic trading (algos) that are creating and profiting from such activity.

All of those who say ‘I just use index funds’ have no idea what they are investing in from a business standpoint. They are essentially allowing black-box models to deploy their investment dollars. [These models] are at the center of the problem with the market mechanism and these investors are actually contributing to the crazy volatility we are seeing, and have been seeing for some time now.

It was one thing when so-called ‘indexing’ was a tiny fraction of the market, but now that almost 35% of invested funds are indexed, it’s an entirely different situation. By the assessment of the many “human” traders we work with (yeah, there are still a few left), a whopping two-thirds of trading activity is now being done by algos/passive.

Couple that massive increase with the regulations spanning the past twenty years that essentially made it unprofitable for brokerage firms to make markets in OTC stocks (those are the small/mid-sized companies), and you have an illiquid market, subject to the whims of the computers.

Of course, as active managers, we will be accused of bias for pointing this problem out: that’s fine by us. After 35 years of watching our industry abdicate responsibility for making real investment decisions and come up with “products” that have nothing to do with financing real businesses, frankly, we have no problem saying what we see going on!

We’ve spent our careers watching the biggest of the Wall Street firms get bigger and fewer in number every step of the way. These same firms have been pushing more and more financial ‘product’ that has nothing to do with raising capital for businesses or providing quality research to real investors. BlackRock now “manages” almost $7 Trillion in assets (or they did, until about three weeks ago).

How do you manage $7 Trillion in assets? The answer is: you don’t. You create as many vehicles as you can that keep the ‘fee train’ going: vehicles such as ETFs and index funds, because when you have that much money to manage, you have to own every stock in the world, as the CEO of BlackRock admitted in an interview five years ago that we blogged about (see THIS POST from 2015).

Those big Wall Street firms also emphasize ‘financial planning’ instead of actual ‘asset management’ that would involve analyzing specific stocks (no offense to financial planners, but they are trained for different skills than stock selection and analysis).

Those big Wall Street firms also tell their advisors: ‘You don’t want to be managing money, you just find it’ — again, de-emphasizing the responsibility of making real investment decisions about individual businesses, which is at the very core of the problem.

This disengagement from business analysis is a big part of how we got here…

This is why we have spent our professional lives promoting the need to take a business approach to investing! No doubt, there is enough uncertainty in the real business world right now for us to sort out.

Fortunately, because we take that approach, we are in touch with the managers of the businesses we invest in as they assess the impact the COVID-19 debacle will have on their business. Most definitely it is not completely clear for a number of businesses.

But we take great comfort in knowing that one of the most important, if not the most important, aspects of our due diligence process is an assessment of management capability. And in times like these, this provides us the confidence necessary to advise incremental additions to portfolios for those who are able, and to absolutely stay the course for all.”

—Gerard Frigon

Today’s Prophecy

The outsider trading scandal stems from the law for information disclosure by public companies and aspiring public companies. These laws prohibit the release of materially significant information unless it is published simultaneously to the world. With the entire field of company disclosure a regulated arena, information emerges only as various forms of processed public relations — zero entropy communications from lawyers and publicists.

Insider trading laws do not prevent criminals from manipulating markets. As I wrote in Knowledge&Power, “The idea that you will frustrate Bernard Madoff by reducing information for everyone else is like trying to prevent airplane hijackings by making all passengers lie about what’s in their luggage.”

By criminalizing inside knowledge and activity, you enshrine the outside traders. The ultimate outside traders are computers. Preet Bharara will never indict a computer. But a computer will never make a foreward looking investment except by accident. Computers manipulate existing data and existing markets rather than imagine a contrarian future.

The outside trading problem is a more serious affliction of our system than any virus from an animal.

Regards,

George Gilder
Editor, Gilder’s Daily Prophecy

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