The Trading Game Is Causing the Manic Market

If this volatility continues, Wall Street may lose Main Street and the economy will be worse off

600 traders computers REUTERS Pawel Kopczynski.jpg

Lots of people are blaming computers and so-called high frequency trading for the insane stock market fluctuations we've seen over the past week. But that's not quite right. Sure, technology is making the dramatic ups and downs possible, but the computer is a mere tool. Even since big investors stopped worrying about company fundamentals and became involved in technical analysis and tricky arbitrage strategies, the stock market fundamentally changed.

The Real Cause of the Problem

The problem with blaming big market fluctuations on computers is sort of like blaming guns for murders. As the saying goes, "guns don't kill people, people kill people." Similarly, computers don't cause crazy volatility, the people who operate and program those computers cause crazy volatility. This is evidenced by traders' love of technical analysis. David K. Randall from AP explains:

Technical traders all but ignore fundamentals, such as corporate profits or expected growth rates. Instead they rely on stock-chart analyses that signal when to buy or sell the entire U.S. stock market.

In the absence of clear signs about the economy's direction, more of Wall Street is turning to technical trading. When the charts say "sell," a herd of sellers emerges, magnifying declines. If prices fall far enough, another wave of technical selling is triggered and the decline is intensified. At some point, a threshold is reached where the charts say "buy," and stock prices get whipped higher.

Wall Street no longer views the stock market as a means to invest in companies that they believe are undervalued based analysis of a firm's earnings and growth potential. Instead, it has become a sort of game. The objective is to find ways to buy or sell stocks and make a quick trading profit. Instead of representing companies, these stocks might as well represent race horses. So long as theories of trading patterns could be developed, it wouldn't matter what lies beneath a ticker symbol.

Tuesday's big gain epitomizes this point. It had nothing to do with investors feeling better about the economy or the companies that saw their stocks rise. Instead, some figured out a clever way to lock in ultra-cheap dollars to buy stocks based on the latest Federal Reserve policy. Once the rally began, the other lemming traders (or more likely computer algorithms) followed.

The Gulf Between Wall Street and Main Street Widens

Because of the stock market's evolution, Americans don't have a chance investing as amateurs. Sure, they could just buy an index fund and do okay. But if the computers powered by technical traders take over, they could see their nest eggs shrink by thousands of dollars in minutes for no tangible reason. How long can they reasonably be expected to endure the fear this would cause? It's easy for a trader on Wall Street to shrug off a 5% loss on a day, because he or she is trading other people's money. It's not as easy for a Baby Boomer hoping to retire in a few years watch the losses rise and assume the market will just go back up eventually.

This is ultimately a bad thing for companies and the U.S. economy. While Wall Street has plenty of cash to invest, surely public companies would be better off if Main Street was also eager to invest in stocks. I worked in finance (on Wall Street even!) for close to six years and now write about business and economics for a living, and even I don't feel comfortable investing all of my savings in the market with this sort of volatility. I just don't trust my money to be subject to the whim of traders who care nothing about company fundamentals and trade based on the whims of technical patterns they follow. I can't be alone.

This sort of volatility will also have spillover effects on the U.S. economy. It's always scary to see the Dow market fall by 500 points repeatedly -- even if it rises the next day. Because you have to wonder: what if it doesn't rise tomorrow, but continues to fall? This sort of erratic stock market behavior is terrible for consumer confidence. Americans worry that their savings aren't safe, so they'll likely cut spending, just in case.

But What's the Solution?

Unfortunately, a clear solution doesn't jump out. Do you end high frequency trading? Perhaps, but you'll still have Wall Street trade based on technical analysis and arbitrage tricks instead of fundamentals. They'll just do it a little slower. The problem will persist: you would have a stock market that's more the field in which a big game is being played than a legitimate marketplace where people can safely invest in companies they believe will grow.

And by killing off high frequency trading, you'll make the stock market less efficient. Are we prepared to have stock quotes with wider bids and asks? Maybe that cost is worth the benefit, but maybe not.

It almost makes you want to scrap the whole thing and do away with the public market entirely. Perhaps companies were better off when they sold stakes in their firm to individuals on a case-by-case basis. But then you lose liquidity, and smaller investors have a hard time entering the market.

So I don't know how you fix this. Technology and quantitative analysis aren't really our enemies, but they certainly aren't helping matters.

Image Credit: REUTERS/Pawel Kopczynski