High-Frequency Trading: Bad

Doesn't it seem like every day, there's a new negative article on High-Frequency Trading? Blogs, newspapers, magazines, everybody has joined in the fun.

Maybe it's because this is a slow summer, news-wise. Besides Iran (already old news), Michael Jackson's death (he's still dead), Gates-gate (getting stale by the minute) and Nicolas Sarkozy's stealth heart-attack, not much is happening. Thus the appeal of a trading style nobody understands or has even ever heard of (never mind that it's basically automatized day-trading), therefore making it the perfect villain, to be blamed in advance for the next crash.

What's more surprising is to read a quantitative finance guru, Paul Wilmott, contribute to the discussion with a simplistic, sensationalistic and pretty mindless article in the New York Times where he concludes with the following platitude:

"Buying stocks used to be about long-term value, doing your research and finding the company that you thought had good prospects. Maybe it had a product that you liked the look of, or perhaps a solid management team. Increasingly such real value is becoming irrelevant. The contest is now between the machines — and they’re playing games with real businesses and real people."

That's pretty rich coming from a guy who had a hand in designing many of the very algorithms he's criticizing and in educating many of the people running them.

Charles Darwin Vs. Adam Smith: A Clash of Narratives

In a recent New York Times thought-provoking article, economist Robert H. Frank submits that 100 years from now, most economists will cite Charles Darwin instead of Adam Smith as their discipline's founder.

He reasons that Smith's famous (or infamous for some, these days) "invisible hand" theory is but a special case of Darwin's "survival of the fittest" theory, which provides us with a much better model for how the real economy works.

According to Adam Smith, "when greedy people trade for their own advantage in unfettered private markets, they will often be led, as if by an invisible had, to produce the greatest good for all." In this narrative, competition spurs innovation which in turn benefits society at large.

In Darwin's theory of evolution on the other hand, "competition favors traits and behavior according to how they affect the success of individuals, not species or other groups". This competition to improve individual fitness sometimes benefits the group, as for hawks whose eyesight has improved over millions of year benefiting both individual hawks and the hawk species at large. In this case, Darwin's narrative closely mirrors Smith's. But in other cases, "traits that help individuals are harmful to larger groups", as for elks whose antlers have evolved into grotesquely massive and complex appendages, helpful in attracting females and fight other males but quite a handicap when running away from a predator in a dense forest.

As Frank points out, "in Darwin's framework, then, Adam Smith's invisible hand survives as an interesting special case. Competition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always."

In Darwin's world, we can never be sure that individual and group interests are aligned. Fitness for an individual in a given situation can spell extinction for the group. Similarly, survival for a group can spell extinction for the population as a whole.

Finance, it appears, lives in a Darwinian world, not in a benign invisible-hand-controlled Smithian one. What better illustration of that point than the recent financial crisis? Each participant in the whole subprime mess was really acting to maximize his or her profits given the regulatory, political and economic environment he or she was in. Unfortunately, acting that way wrecked the financial system as a whole so badly it might be extinct as we speak if not for massive government intervention (the jury's still out on the level of damage that has been done and the longer-term consequences).

Laying it on a Little Thick

Paul Krugman, whom I otherwise admire, is laying it on a little thick these days about how he was right all along in predicting the inadequacy of the fiscal stimulus package. He's also very proud of the fact that he was also right about the political ramifications of that inadequacy, namely that, should the stimulus plan prove too timid, the Obama administration won't be able to go back to an already reluctant Congress and ask for a second round of fiscal stimulative medicine.

I don't know about you but, to me, this whole line of reasoning sounds unhelpful at best, conceited and a bit disingenuous at worst.

First of all, announcing the stimulus plan before the Inauguration and having it passed a few weeks into the new presidency was itself a political, psychological and economic coup. It gave the country a much-needed psychological boost that translated into an unexpected and welcome rally in all assets (T-bonds excepted of course). Even if you ignore its effects on the financial markets (which Professor Krugman often dismisses as irrelevant), the plan also had an undeniable effect on the economy: the "green shoots", while a little overrated and maybe temporary in nature, were real enough.

Second of all and more importantly, the stimulus package is back-loaded, meaning most of its effects haven't been felt yet. In other words, it's way too early to pass judgment on it, especially when, according to the Government Accountability Office's report released two days ago, less than 10% of the $787 billion has been spent.

There is no need at the present time to start lobbying for a second stimulus package when the first has just started working its way through the economy and when many people are doubting its very efficacy.

Bye Bye Green Shoots?

After yesterday's dismal employment report, pundits have started pronouncing the green shoots mantra dead and buried. Technically though, things are not that clear. Even after yesterday's brutal sell-off, we are still above significant support areas. As can be seen in the chart above (click to enlarge), the S&P500 might be in the process of forming a Head and Shoulder formation (the neckline is the blue line in the chart) but for the (bearish) H&S to be completed, the index would have to break 888 decisively. And even if it does, there is still that line-in-the-sand support above 875 to contend with (orange line in the chart).

So, granted the momentum has turned quite drastically and there are a lot of scared bulls out there as well as highly motivated (and well-capitalized) bears, but the war between those two groups is still going on and the outcome is not yet clear.