Is The Stock Market Rigged?

Michael Lewis’ new book Flash Boys has a great title and the answer “Yes!” to the question.

By way of disclosure, I have not yet read it, but I have seen reports and have had an interest in High Frequency Trading, (HFT) for some time.  There are at least two other articles in the archive devoted to the subject.

If you believe the hype, the stock market is a rat’s nest.  While there is little evidence to suggest that there are no rats on Wall Street, it is pushing the limits of credulity to claim that the market is rigged.

Flash Boys claims that there are evil operators who front run orders, spoof the market and execute trades that take advantage of inter-market price anomalies.   Probably all true.

Does it matter?  Not to me.

I don’t buy or sell enough stock in a year to care that someone made a few cents per share at my expense.  The amount is less than the round-off would be in my price decision.  On the plus side, because of HFT, the spread between bid and ask has been falling over the years.  That makes me a little money.

If I traded a few billion dollars of stock a year, I might care.

None of the exposed swindles are new.  Now they are efficient and harder to detect.  Front running and spoofing have been around as long as the market.  Sorting out anomalies has been around longer.  People do that every day.  Have you noticed how many 500 ml of water from Costco show up at other retailers?  Buy retail, sell retail and higher in a different market.

HFT makes markets more efficient.  It certainly straightens out the price anomalies and I cannot imagine how anyone could run an end of day scam today.

I think HFT is a problem but not because it provides a home for miscreants to exercise their talents.  The problem is more subtle.

The time an HFT trader holds stock is in the order of 60 milliseconds.  An investor looks at longer periods.  Maybe not forever as Buffett suggests, but probably more than five years.  The difference starts to matter when the investor tries to assess volatility (risk) based on market information.  If half the trades are begun and finished in a 16th of a second, the derived statistical information may be less useful than if the average trade is cash to cash over five years.

We know some statistical data no longer has meaning.  Volume and price, for instance, were once highly positively correlated.  No longer.

Does volatility still mean anything when most HFT trades have zero risk?  They know the price they can sell at, before they buy.  Try that with a five year hold.

Practice has discredited The Efficient Market Hypothesis but the theory remains.  HFT is an important element in efficient markets and may hold information that is valuable.  It will not, however, be data that supports annual volatility as risk, and diversification as the solution.

The information we have now comes from markets where half or more of the trades occur in a time that is only one one-hundred-millionth of a market year and where the price variation is in the one twentieth of one cent range.  These are not  investment centric variables.

While my instinct is that Flash Boys is a fine platform for the author to make money, and I am okay with that, it could be an important book if it causes investors to think.  Statistics in the stock market are no longer definitive.  They show deep tendencies possibly, but they say little about risk.

You cannot draw good information out of data that is inconsistent with your purpose.


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Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

2 Comments on “Is The Stock Market Rigged?

  1. The stock market is rigged but not by frequent trading or any big investors (banks, billionaires). It is rigged by central banks of major economies who determine interest rates (Federal Reserve Bank in the USA, etc.). The only reason why USA markets went up from February 2009 is a close or equal to zero interest rates in the country.
    This policy can’t be followed indefinitely and this quarter a fall of the market started.

    • While I think interest rates are too low and should go higher soon, I am not so sure that rates have rigged the economy. Despite their negligible level there is not a lot of borrowing. I think that is because people intuitively know that they must pay back the principal and in times of uncertainty that is a more compelling concern. Business needs fewer disincentives, not more incentives. Employed people need greater predictability in respect to their future prospects. The stock market, in the short run, is not a good indicator of anything. As people begin to trust a bit, the economy will go up and the stock market may follow. I wish I knew when.

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