The Sixty Minutes program on Sunday night about High Frequency Trading, based on the book "Flash Boys: A Wall Street Revolt" by Michael Lewis, has become the central focus of the investment community. Today, Attorney General Eric Holder announced an investigation into the improprieties involved with HFT market makers. Accompanied with the Justice Department query is an additional look by the Securities and Exchange Commission. Several CEO's of large companies like Charles Schwab and Toronto Dominion Bank have jumped into the fray by stating they believe high frequency trading should be banned.
There are many issues involved with high frequency trading, but much of it centers around broker dealers using technological advantages of high speed fiber lines, superior software design and coding, and the implementation of routing techniques to either front run trades, create dummy transactions and use the information to arbitrage price differences between dark pools and the the open market, or a combination of the two schemes. Mr. Lewis's book and the 60 minutes piece, while attracting a lot of attention and selling quite a few books, ignore the past five to ten years as this has been taking place for quite some time. Wall Street brokers have always benefited by scalping more than their fair share from investors, the difference here is the spreads are narrow because of decimalization and computer trading. History has shown for a hundred years the investment banks, exchanges, and broker dealers control the the mechanics of buying and selling securities. If you have read Warren Buffett's and Charlie Munger's opinion's on trading and why investors should minimize it, as well as the fact they have long thought high frequency trading was front running, none of these issues are surprising. What is surprising, though not shocking, is how long the regulators have not been paying attention.
Even further, using the term that "the market is rigged" is also in many ways quite irresponsible. At no point during the television segment was any kind of attempt made to break down what the capital raising process is, what ownership of a stock is, how many people own stocks, and then tie trading costs into any of these basic principles. Also, at no point was anything mentioned about what the alternative to the "rigged market" might be. If you are advocating the market is rigged, the logical conclusion for a viewer would be to stay away from that entity. If you stay away, where else might you go? How might staying away from the nefarious activity affect life goals in the future? At a time where the general public has very little faith in stocks, irrespective of the massive gains for shareholders over the last five years, the media's sensationalism make any kind of a rational and fact based discussion difficult. During the week, Mr. Lewis and the protagonist of his book, who set up a competing exchange free of conflict and one which neutralizes HFT advantages, and the CEO of a competing trading company lined up on CNBC to have a discussion about the matter. Naturally, the result was a vigorous argument about the merits of HFT trading by those involved. The bottom line is high frequency trading is indeed not good for market participants as it raises the costs of buying and selling assets, and allows some to benefit at the expense of others in what can be viewed at as a zero sum game. However, I might also point out the guys who are the sharpest and wealthiest investors, Buffett and Munger, made their money investing capital in equities. Speaks for itself, I'd say.
The jobs report today was not the greatest, and the market continues to sell off hard, especially in momentum, technology, and biotechnology related names. The lack of any kind of accelerated strength for job creation continues to lend fuel to the fire that the current policies being employed are at best inefficient and not well thought out. The only real job creation which took place was from the private sector, what a shock, huh? The misguided notion of an enlarged role for government is the underpinning of the Affordable Care Act, which has recently made headlines about meeting the seven million enrollment number. One notices nobody mentioning the number of those who have made their premium payments. I suspect the chicken has yet to come home to roost on the public's verdict of the Affordable Care Act.
In the oil market, the continued movement to rationalize portfolios and asset ownership by the large integrated oil companies is occurring all over the globe. Whether it is in North America, Europe, Africa, Australia, or Asia, the largest oil enterprises are starting to make the hard decisions about what assets they want to own and where they want to own them. Whether it is Shell selling in Nigeria, BP closing down a refinery in Australia, or Exxon scaling back projects in North America, big oil knows their capital investment programs and returns on capital are going to evaluated very closely every earnings report and year, and it will probably not change for quite some time. As a shareholder, these are good things as capital allocation decisions are always crucial for the future, no matter how large the entity is.
Barron's had a cover article last week on the increased possibility of $75 oil because of technological improvements in a variety of different ways to potentially increase the supply of oil in the future. Some of us who majored in or studied economics also know there is another part of the equation, which is demand. I would argue the Barron's piece missed the demand side of the equation and where the growth of demand will go, especially in Asia. The largest oil companies all predict the majority, if not all of the expansion of demand will take place in Asia. If you look at the projections of both supply and demand, it is hard to see how oil goes to $75, unless supply absolutely explodes. In addition, there is the additional variable which has to be considered, and that is how oil gets moved. Given the fact that we in the United States currently have been waiting six years to find out whether the Keystone pipeline will be approved, a point recently made by Boone Pickens, lets just say our ability to streamline the process for different ways to move oil and gas ain't exactly perfect. Some in Europe want the U.S. to just start shipping liquid natural gas to help relieve Europe's dependence on Russia's Gazprom. Seems like a good idea, right? You would think Mr. Obama would endorse it and go with it. Even if he did, it takes five years to start making the terminals and planning the logistics to build the facilities. The private sector is itching to get it done and has been for years. The problem is the leadership and it's loyalty to a constituency which does not understand the strategic importance of energy. Yes, the environment matters, and the future of the planet is important. No one denies it, and the oil companies work in nearly every kind of environment there is. In fact, the engineers and scientists from the largest energy companies probably care as much or more about the planet then those who continually criticize and complain about them, including the pandering politicians. The political positions in the United States and Europe regarding energy continue to leave our citizens in a far weaker situation than we ought to be.
Elsewhere in the market, it seems some believe bank lending might be turning a corner. Mortgage lending is still a problem and is showing contraction, but business lending is expanding. Any expansion of interest rates would improve banks net interest margins, and the large money center banks would benefit immensely if it were to materialize. Last week the regulators gave the red flag to Citi's capital plan and turned down a potential dividend increase. The fact Citi let $400 million dollars of loans go misplaced in Mexico I am sure did not help their cause. Prudent lending is not an easy job, and don't the boys at Citi know it. Having gone through four CEO's in six years do not inspire confidence, let alone having an equity lose ninety percent of it's market value. Still, Bob Rubin and Sandy Weill get no heat, so I guess, as they say, timing is everything.
Thank you for reading the blog this week, and I am sorry it took so long to post. Any comments, thoughts, or questions on the material are most welcome and please share them!
Y H &C Investments, Yale Bock, and the family of Yale Bock own positions in securities mentioned in the blog post. Investing in stocks can lead to the complete loss of your capital. As always, on any company mentioned here, past performance is not a guarantee of future returns. Investing involves risk of losses on invested capital. One should research any investment and make sure it is suitable with your objectives, risk tolerance, risk profile liquidity considerations, tax situation, and anything else pertinent to your financial situation. Also, the CFA credential in no way implies investment returns will be superior for any charter holder.