On the Street, the Tough Crowd Rules
businessweek.com
AUGUST 6, 2004
<< NEWS ANALYSIS
By Amey Stone
Ruthlessness and randomness prevail thanks to hedge funds, leverage, and program trading. What's a small investor to do?
Imagine the prototypical professional investor. If you picture someone sitting behind a desk, reading annual reports and pondering the valuations of companies like Coca-Cola (KO ) and General Electric (GE ), you'd better think again.
The big players in today's market are a different kind of crowd: brainiac hedge-fund managers using complex algorithms to identify obscure arbitrage opportunities, multibillion-dollar mutual funds buying the entire S&P 500 through program trades, and frenetic in-house traders at giant brokerage firms making snap decisions on the direction of emerging-market debt securities (see BW Online. 8/6/04, "Hedge Funds Are Everyone's Problem").
QUICK ON THE DRAW. Trading done by this crew is fast, short-term, and often highly leveraged. It is as likely to be driven by cues from a computer or technical chart as it is by any traditional stock analysis. Increasingly, the goal is not just to trade off news, but to trade ahead of the news -- to anticipate it.
"The rule used to be, wait until you see the whites of their eyes," says Michael Panzner, a trader at Rabo Securities and author of The New Laws of the Stock Market Jungle, which details changes in the investment environment. "Now people aren't waiting until they see anything. They are shooting at the air, hoping the bullet hits."
For individual investors, the effect of all this is to make the markets more unpredictable than ever. Wondering why a stock went up? It may have nothing to do with what's going on at the company (See BW Online, 8/6/04, "The New Rules of Investing"). Longer-term investors should do their best to ignore all the noise. But if your strategy relies on short-term indicators, "Don't kid yourself," says Greg Forsythe, who directs Schwab's equity ratings group, "there is a lot of competition out there. You are swimming with the sharks."
HIGH-TECH SWINGS. This shift in speed and predictability of stock investing has taken place gradually over the past decade, and is likely to continue as markets become ever more high-tech. On Aug. 2, New York Stock Exchange chief executive John Thain announced his proposal for a hybrid market that would ramp up use of the exchange's electronic trading platform at the expense of its traditional system where real people, known as specialists, called the shots from the floor of the exchange.
Program trading (baskets of more than 15 stocks worth more than $1 million and trading all at once, as the exchange defines it), now makes up more than 50% of trading on the NYSE (up from less than 20% in 1998). But market strategists estimate that about 75% of all trading done today is computer-driven. Program trading first made its appearance in financial headlines because it was believed to have contributed to 1987's stock market crash. Since then, exchanges have instituted limits on such activity that kick in during big market swings. Nonetheless, sudden, sharp intraday spikes or sell-offs in the markets are routinely (and inexplicably) triggered by program trades, strategists say.
Asset flows into hedge funds -- those high-voltage, loosely regulated, opportunity-seeking funds crafted for high-net-worth investors -- continues to surge. Hedge-fund assets have grown from about $50 billion in 1990 to more than $850 billion in 2003 and are expected to soon reach $1 trillion. Hedge funds often use strategies involving derivatives, short-selling, and futures and options. One sign of their impact: The Options Industry Council reported July 7 that the month's equity option volume was running 42% higher than last year.
BYE-BYE, LITTLE GUY. And it's not just hedge funds using these strategies. Brokerages and investment banks are increasingly making profits from their own proprietary desks, where traders act as in-house hedge-fund managers investing the firms' own capital. Even the more plain-vanilla mutual-fund industry is increasingly turning out funds that use hedge-fund-like techniques -- short-selling and layering on options -- to improve returns while reducing risk. At least that's the theory.
All this is happening at the same time individual investors continue to take to the sidelines. At Charles Schwab, still the king of the discount brokerages despite a slump in its business, revenue from trading plummeted 20% in this year's second quarter vs. the first. Flows into mutual funds, strong early in the year, dried up in May and have limped along since then.
More professionals who employ a buy-and-hold strategy are joining those individual investors on the sidelines. Star Value funds (which invest in undervalued stocks for the long-term) are sitting on more and more cash. For example, the Clipper Fund (CFIMX ), and Longleaf Partners (LLPFX ) both have about 30% of assets in cash, according to Morningstar. "For the time being (a short time we hope), it is better to do nothing than to do something dumb," Clipper managers wrote in their first quarter letter to shareholders.
The king of long-term value investing, Warren Buffett, was holding $36 billion in cash in Berkshire Hathaway (BRK.a ) at the end of 2003, up from $13 billion at the end of 2002, and $6.5 billion at the end of 2001. The reason, he explains in this year's shareholder letter, is that he's not finding enough businesses or stocks to buy with "opportunities for significant profit."
IT'S A JUNGLE. For individual investors, Buffett's unease and the new frenetic investing climate seem to argue for staying out of the market. If Oracle of Omaha doesn't see opportunities, the logic goes, how much hope does the small investor have? Yet some experts argue that just the opposite is true: There may be more opportunities than ever for small investors to take advantage of temporary inefficiencies created by all this short-term trading.
"My advice to individual investors would be to swim in a different part of the ocean," says Schwab's Forsythe, whose rating system has far outperformed market indices in the past year. "Be longer-term oriented. Use value-oriented criteria to select stocks. Leave all the momentum plays and technical indicators to the hedge funds."
In the long term, fundamentals like earnings growth and valuation will hold sway, even if the short-term picture is increasingly distorted. As Panzner explains in his book, even small investors can thrive in the stock market jungle if they know how to maneuver amongst the large and voracious predators that surround them. Understanding the impact of hedge funds, program trading, and derivatives can help. "The universal rules haven't changed," he says. "It's always a case of know your enemy." Being in a more ruthless and random environment may feel more dangerous, but investors who do their homework can still make money, the experts say. >> |
