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Insight: The madness of Wall Street

Traders work on the floor of the New York Stock Exchange
Traders work on the floor of the New York Stock Exchange

By Matthew Goldstein, Lauren Tara LaCapra, Jennifer Ablan and Joseph Giannone

NEW YORK (Reuters) - The best thing to be said of the recent stomach-churning turmoil on Wall Street is that it's taking place in August, a time of year when many people are lounging at the beach or camping in the woods and not paying attention to stocks.

But for everyone else not on a 'stockation,' watching the markets rise and fall like giant ocean swells has been an unnerving experience that some finance professionals worry could reshape investor behavior for months and years to come.

"Everyone felt this was idiotic," says Susan Kaplan, president of Kaplan Financial Services, referring to last week's volatility. "Most clients didn't want to deal with the markets anymore and went back to their summer vacations," said Kaplan, whose firm manages about $1.3 billion in customer money.

In the short term, doing nothing may well prove to be the best strategy for dealing with the kind of dizzying gyrations that occurred the week of August 8 in the U.S. stock market. At one point, the S&P500 was down 8 percent for the week before it erased all of those losses and then some in the ensuing days.

Thursday brought another August storm. The S&P500 plunged 4.46 percent and the benchmark 10-year Treasury note yield fell below 2 percent for the first time in 70 years. And the trouble is this turmoil may not be some temporary anomaly.

FREE FALLIN

Experts say investors should expect even more volatility in stocks, as herd trading by hedge funds, knee-jerk trader reaction to news and lightning fast computer programs combine to make for a new and uncomfortable normal on Wall Street.

This new trading frontier even has its own signature milepost, something called "a liquidity black hole." It's a trading phenomenon in which there's so much intense selling pressure in big-cap stocks that it sucks all the oxygen out of the market and stocks plunge precipitously - as on August 8 when every single stock in the S&P500 ended the day in the red.

"We have to be aware that we can be hit by one of these liquidity black holes with ever increasing frequency," says G. Andrew Karolyi, a finance professor at Cornell University Johnson Graduate School of Management. If you are a long-term buy and hold investor you better be aware of these and not panic when you see it."

Yet some fear that's just what ordinary investors will do as this new hair-trigger trading dynamic becomes more common. There's a concern that frenzied trading could drive people further away from stocks at a time when, other than gold, there are few assets generating any kind of substantial return.

And that's something that could have long-term ramifications for the ability of investors to build retirement nest-eggs, especially given the historic poor ability of retail investors to time market swoons and surges. A portfolio with 20 percent in cash, 50 percent in a bond fund yielding 3.42 percent a year and 30 percent in stocks isn't going to enable a person in their 50s to retire any time soon.

Also if investors flee stocks it could make it harder for small, niche companies, such as ones in the biotech or clean energy sectors, to tap the public markets for capital. Or more of those companies might take their capital-raising business overseas to places like Hong Kong, which would be another blow to Wall Street.

"The market we are operating in is markedly different from five years ago," says Andrew Lo, a professor of finance at the MIT Sloan School of Management, who frequently writes on hedge fund trading strategies and markets. "We are seeing extraordinary emotional reactions from central banks, politicians, regulators and investors. That kind of reaction is not conducive for building long-term wealth. We have an environment that is highly unstable."

One might say Wall Street is a bipolar market that veers from despair to euphoria with each passing news headline.

19TH NERVOUS BREAKDOWN

Over the past several weeks, stocks prices have swung widely based on a range of factors: the perceived progress of European leaders in dealing with the eurozone debt crisis; the fears of a double-dip recession in the United States; the fallout from Standard & Poor's downgrade of U.S. debt; and whether the Federal Reserve will embrace a new round of easy money to jumpstart the economy.

L. Randall Wray, a professor of economics at the University of Missouri-Kansas City, says much daily trading in stocks is like a self-fulfilling prophecy. "What matters is what the markets think not what people in the markets believe," says Wray. "Traders are constantly trying to guess how daily events might affect other market participants."

This guessing game is largely being driven by super-fast computers with algorithmic programs designed to react to headlines and overall market trading patterns. The Tabb Group, a financial markets' research firm, estimates that during the frenetic week of August 8, high-frequency trading firms and strategies accounted for 65 percent of the daily trading volume in the United States.

The power of the machines over trading is one reason why technical analysis, often pooh-poohed as Wall Street alchemy, is gaining more believers among traders. There's more interest than ever in computer programmers who can write algos to simply buy and sell stocks whenever the S&P hits a predetermined target, or some bizarrely-named trading pattern such as a "Death Cross" forms on screens.

Some of the surge in volatility is also attributed to a growing legion of money managers who frequently trade exchange-traded funds - which are baskets of stocks, indexes and other assets - as a way to hedge their positions.

"There's a different dynamic now because of the pervasiveness of high-frequency traders and hedge funds," says John Longo, chief investment strategist at MDE Group, which manages $1.3 billion in assets. Longo, also a finance professor at Rutgers Business School in New Jersey, adds: "The down-5-percent one day, up-5-percent the next day volatility wouldn't have happened in the past."

STORMY WEATHER

The trouble for ordinary investors is that there are no good market forecasts for predicting what might spark a liquidity black hole. Fear about the United States and European countries slipping back into recession is a legitimate concern that could have real impact on corporate profits and stocks. But when traders act on those fears at lightning speed it can result in seemingly irrational sell-offs.

Take the scary 6.66 percent drop in the S&P500 on August 8. On that first trading day after the credit rating arm of S&P stripped the U.S. of its vaunted Triple AAA debt rating, all 500 stocks in the index closed the day in the red.

The selling was so ferocious that shares of McDonald's Corp, for instance, fell 3.5 percent to $82.11, even though the fast-food giant reported a 5.1 percent climb in same-store sales for July, higher than analysts had expected.

Such selling with no regard to corporate fundamentals makes the notion of stock picking seem quaint.

Keith Wirtz, chief investment officer at Fifth Third Asset Management, with $18 billion in assets, says the indiscriminate selling means "good stocks are going down at the same pace as bad stocks."

Karolyi says the waves of wholesale selling driven by liquidity black holes are not just the byproduct of the over-computerization of trading, it's the end result of too much "group think" by institutional traders.

He says Wall Street first saw this in August 2007, when dozens of quant hedge funds suffered big losses at the start of the financial crisis because the algos they employed were all buying and selling the same securities. This flawed thinking by some of Wall Street's brightest math geeks was an early warning sign of even worse group think to come with regards to the value of securities backed by subprime mortgages.

Karolyi says his research, which will be officially published later this year in The Journal of Financial Economics, has found the phenomenon of liquidity black holes is spreading beyond the U.S. to other stock markets. That is problematic because the effects of liquidity black holes can be profound.

Critics of high-frequency trading firms argue that the May 6, 2010 "flash crash," in which the Dow Jones Industrials plunged 1,000 points in less than 20 minutes, was caused in part by an absence of liquidity or traders making markets in stocks. While securities regulators have never identified a single cause for the flash crash, they have noted that the rapid collapse of stock prices was exacerbated by some high-frequency trading firms turning off their computers and not making trades.

Some are starting to worry about the impact on ordinary investors of the rise of the machines and all these unforeseen consequences. These Wall Street professionals wonder whether events like the flash crash and the frenzied trading of this month will push average investors further away from stocks and into low-yielding money market funds and bond funds.

"The last 10 years have been a nightmare in this business," says Dave D'Amico, president and chief market strategist at Braver Capital Management, which has $575 million in customer money. "People distrust Wall Street at one of the highest rates I can remember."

Evidence of that distrust is already apparent. Over the past two weeks, retail investors pulled $17.4 billion out of U.S. equity mutual funds, according to Lipper, a mutual fund information service. Investors have been backing away from stocks for some time, with many retail investors missing out on a sizable chunk of the 5,000 point surge in the Dow Jones Industrials since the markets bottomed in March 2009.

According to Strategic Insight, a mutual fund consulting firm, stock mutual funds in 2009 took in about $85 billion as the markets were beginning to rise. In comparison, a record $425 billion was invested in low-yielding bond mutual funds.

This trend of retail investors preferring bonds over stocks continues to this day, even as the yield on the 10-year U.S. Treasury hit 1.98 percent on Thursday. In 2010, investors added $222 billion more to bond funds than they withdrew. Yet despite an average 17 percent return last year for the average U.S. stock fund, retail investors took more money out of those funds than they put in, according to Strategic Insight.

"Americans are scarred by the devastating market crash of 2008," said Tom Roseen, senior research analyst at Lipper. "The gut wrenching losses of this period are still fresh in everyone's mind."

CRUEL TO BE KIND

The tumultuous trading of August will only reinforce those painful memories.

Retail investors have notoriously bad timing. For the 17th time in as many years, Boston-based research firm DALBAR found that the 20-year returns realized by mutual fund investors lagged the markets thanks to ill-timed buys and sells driven by psychology. "At no point in time have average investors remained invested for a sufficiently long enough period to derive the benefits of a long-term investment strategy," DALBAR wrote in its 2011 investor behavior analysis.

Nonetheless retail investors, via their stock mutual funds, own a sizable chunk of America's publicly-traded companies. Strategic Insight reports that U.S. mutual funds and exchange-trade funds hold $4 trillion in U.S. stocks, or 27.7 percent of the total U.S. market capitalization.

Wall Street investment firms, of course, have a big stake in dissuading investors from turning their back on stocks or mutual funds. That's especially true for a big retail brokerage firm like Charles Schwab, which has marketed itself as a place for individuals to control their financial destinies.

Walter Bettinger, Schwab's chief executive officer, concedes that the current market turmoil will prove difficult for the online brokerage's less experienced customers.

"If someone's idea of investing is sitting in front of their computer without a strategy, of seeking gains through trading against machines making millions of trades a second, that's a tough row to hoe," says Bettinger.

He says the largest online investment firm is trying to move more of its customers to a mix of do-it-yourself investing and guidance from a financial consultant. He expects that to be an easier sell if extreme volatility continues.

The danger for Schwab and all of Wall Street is retail investors become ever more cautious and simply sit in cash, Treasuries and low-yielding bond funds.

And the danger for retail investors is they end up forsaking stocks and start seeking higher-yields in speculative investments that promise returns too good to believe.

(Reported by Matthew Goldstein, Lauren Tara LaCapra, Joseph Giannone and Rodrigo Campos; editing by Claudia Parsons)

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