The title of today’s article is based on a quote from the recently departed Ralph Kiner, a member of baseball’s Hall of Fame, and a long time broadcaster for the New York Mets. Mr. Kiner was knowledgeable. He was also entertaining, though often unintentionally. Substitute “Branch Rickey” for “Adam Smith,” and you have one of the more famous Kinerisms.
The Wall Street Journal (WSJ) published a story a short while ago about a mind boggling technological advance providing some stock traders with critical information a nano second ahead of the competition. The latest chapter in the quest to reduce trading times to zero, involves laser beams mounted on roofs of buildings and towers in New Jersey, linking the New York Stock Exchange with the NASDAQ trading center.
This story received just mild attention because the quest for warp speed trading has been proceeding at considerable speed itself since at least the late 1990s. Speed as a factor in trading is not new. Adam Smith recognized the advantages of higher speed trading. As far back as the late 1700s, the most ingenious and best equipped traders used carrier pigeons to gain an edge.
High Speed Trading (HST), and its companion, Algorithmic Trading (AT) — am going to abbreviate this as HST_AT — have received enormous attention. Most of the attention has been around issues of fairness (how are the “little guys” in the market affected?); and stability (the potential for HST_AT to cause trading meltdowns). These are very important issues. But lost in most of the coverage are questions around the efficient and intelligent allocation of capital.
Classic capitalism, or at least the version I was taught, starting with the “investment clubs” we joined in high school, stressed the intelligence and efficiency of free markets in channeling capital – directing it to the best ideas; the best (new) products; the furtherance of high demand products and services; and rewarding businesses which are managed well; have already achieved a degree of success, and deserve a chance to grow.
This has always been the core appeal and reason for capitalism. This is how capitalism is contrasted with horribly inefficient methods of capital allocation, like Soviet Five Year Plans; or even (as many argue), European social-democrat, welfare states.
Equity markets of course have never functioned in total accord with this ideal. From the start, there has always been some form of “technical trading.” That’s where investors look more to statistical patterns in stock prices to make trades, instead of looking to the underlying fundamentals of companies — the kind of information found in quarterly financial reports. The technical traders “progressed” to mathematical algorithms (much more complex than anything you learned in Stat 101). HST, in turn, can be considered a type of algorithmic trading.
Altogether, the intelligent allocation of capital seems to be an after thought, or a happy by-product (maybe) of HST_AT. Anywhere from 50 to 70 percent of trading in equity markets is based on HST_AT. And this doesn’t include the “small investor” using technical tools and rules of thumb furnished by Charles Schwab or Motley Fool, which are often short on financial and business fundamentals. In fairness to Schwab and Motley, they also give small investors some tools and information to conduct trades the classic way.
Before we jump to the conclusion that, in practice, hardly any investment is driven by conscious deliberation about the best ideas, products, services, and most effective companies, remember that a great deal of capital investment happens outside of equity markets. A venture capitalist; a small business entrepreneur; or an existing business investing profits in new ventures, are not using mathematical algorithms or Cray computers (for the most part) to drive their decisions. (Unfortunately, I don’t know what proportion of total capital allocation is accomplished via equity markets; and have not been able to find the answer).
The reminder that a lot of investment is still driven by classic concepts of capitalism, may be soothing; but we still don’t know how much better (or worse) capitalism might function if HST_AT were more highly regulated, or even banned, as Stanford, Nobel Laureate economist, Michael Spence,has proposed.
Even more worrisome – today, a lot of deliberate, “intelligent” capital allocation is channeled to high tech toys, like consumer shirt button cameras, which have a lot of entertainment value, but don’t add much to productivity or materially improve lives. (I posted on this earlier). Still, I am more worried about practices like instantaneous trading, which don’t appear to help anyone but the highest speed traders, than I am about the tiny cameras or instagram, which have value beyond being toys.