Why is Wall Street Killing Market Capitalism?

By James A. Kidney

Happy birthday, Vanguard S&P Index Fund!Happy Birthday Desktop Background

You turned 40 years old on August 31 and you are the granddaddy of index funds, says a congratulatory article in The Wall Street Journal.  You also are very healthy and growing like a newborn.

But investing in the Vanguard S&P 500 or other such funds will not save “market capitalism” which, at about 250-years-old is suffocating to death — thanks to Wall Street.

Two other Wall Street Journal stories provide signs — as if any more were needed — that the stock markets no longer function as places where people and institutions make bets on those public companies that are expected to perform well and those expected to perform poorly. That is, or was, the sole utility of stock markets — to reward companies with a bright future and punish those that misstep.  It was the way capitalism among public companies is supposed to work.

Instead, as all interested parties are well aware, computerized trading has transformed the markets into a series of digital zeros and ones in which small changes in price, often irrelevant to corporate prospects, cause big banks and their larger investor customers, such as hedge funds, to buy or sell securities for fractions of pennies of gain.

These trades, which are collectively substantial even if the profits are in pennies for each trade, have little or nothing to do with corporate performance.  Even the fastest news service cannot report corporate activity in nanoseconds.  Instead, computerized trading is simply ultra-responsive to trading itself.  If a shareholder in Company X decides he needs to cash out to buy a new house, the algorithmic or “flash trading” will reflect the sale if it lowers the stock price and will result in more trading.

One of the other Journal stories describes “just how muted market activity has been,” focusing on the 17 trading days since last Thursday in which the S&P 500 moved less than 0.75% between its daily high and low.  “That is the most consecutive days with such narrow trading range in records that go back to 1970,” according to a market strategist cited by the Journal.  The streak broke last Friday, but resumed this past Monday.  The Journal blames this lull in part on summer vacations as Labor Day approaches.  But the fact is that market ranges have been small by historical standards for the last four years.  Below is a table of the VIX Index, also known as the “fear index,” which measures the volatility of S&P 500 index options — the market’s expectation of stock market volatility over the next 30 day period.

Stock Markets on a Ventilator?
                                                                    Stock Markets on a Ventilator?

Of course, market volatility can change any time, and very quickly.  Bad economic news is the most common reason.  The news since 2012 has been mixed, with an economy improving but only slowly.  The rising tide does not lift all boats given, among other things, extraordinary income inequality,  pockets of persistent unemployment, and twin fears of a jobless digitized world and loss of existing jobs to cheaper companies abroad.  This could explain the lack of volatility in the market.

But one of among many questions that arises is:  Why, over these years of economic uncertainty, have we not seen securities moving up and down sufficiently to meet historic market performance?  After all, many companies participate in the market, some gaining advantage from current economic times and others suffering.  While surely some companies have suffered or prospered beyond the average in the market, why is, overall, trading so quiet?

Could it be that almost no one is “betting” on individual corporate performance and that, instead, the stock market is merely a kind of roulette wheel in which chance price changes result in small trades?  Is flash trading all the stock markets really are today?  Sure, the vacations of professional traders (there are some left) may be cause for exaggerating the effect in August, but the table above suggests the absence of trading judgments based on corporate performance is of longer lasting duration.

As do some 50th anniversary observations about Vanguard-fathered index funds.

For example, the Journal’s Jason Zweig noted in a column last Friday headlined “Are Index Funds Eating the World”:

“Over the past year, $310 billion has fled actively managed funds run by people who try (and often fail) to pick the best stocks and bonds.  Meanwhile, $409 billion has poured into passive, or index, funds that seek to match the market rather than beat it. Could these autopilot portfolios become so popular that they distort the financial markets?”

S&P 10 year returnsThe two biggest index funds, Vanguard and BlackRock, may already own at least five percent of more than 2,600 companies worldwide, Zweig reports, and index funds account for five to 10 percent of daily trading.  Since index funds do not actively trade based on prevailing prices, if everyone owned index funds, “no one would be doing” the job of figuring out what securities are worth, according to one observer at Sanford C. Bernstein, who wrote a report titled The Silent Road to Serfdom:  Why Passive Investing is Worse than Marxism.

Allowing for the same exaggeration as in the report title, maybe the feared serfdom already has arrived.  As two categories of buyers and sellers grow and dominate the markets, there will be little or no figuring out what companies, and, therefore, the securities of those companies, are worth.  The categories are passive index funding and trading accounts that rely on “passive” flash trading.

Is it any wonder that the average investor increasingly relies on index funds rather than trying his or her hand at stock picking?  Wall Street has rigged the game. Why should a serious stock picker review a 10K or Q and peruse the news for updates on corporate fortunes when even a solid stock pick doesn’t provide any more market gain than investing more cheaply in a good index fund?  This is especially so since the small investor doesn’t get the advantage of flash trading on small price changes (which also carry accumulating execution costs beyond what a small guy or gal can afford).

Is Wall Street goring the Golden Goose by making the market, always a risky business, one in which intelligent evaluation of securities by either savvy private stock pickers or professionals makes no difference because of automated trading, which drives most investors to index funds?

Short term, the big investment banks make big money.  The long term?  Does anyone care anymore?

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