Expectation and the Stock Market - High Frequency Trading

I have a great deal of respect for Alan Abelson and Randal W. Forsyth, both at Barron's. I think their insights are the best on Wall Street and they are not afraid to go against conventional wisdom. In comparison to the financial analysis that I see on many television programs, the work of Abelson and Forsyth is far superior.

The following article chronicles some of the issues that make me feel uncomfortable about the US stock market going into the Fall, namely the abandonment of fundamental analysis as the basis for trading stock.

Abelson, Alan, 2010. Let's hear it for bad estimates. Barron's, Sept. 4.

This is an important quote from the article:

"You'd never know it by the joyous reaction of investors, but everything on the job front in August didn't come up roses. The unemployment rate inched higher, to 9.6%, from 9.5%, but mainly because of a sudden jump in the labor force. And all told, 54,000 jobs disappeared last month, owing to the loss of 114,000 Census slots. That was just about offset by the 115,000 jobs conjured up by the BLS' magical birth/death reckoning."

Besides, the birth/death adjustments there are deeper concerns to consider,

"Noteworthy, too, is that U6, the most comprehensive count of the underemployed plus the unemployed, increased to 16.7%, from July's 16.5%. And, as Bank of America Merrill Lynch's Neil Dutta notes, the breadth of hiring weakened, with the payroll diffusion index slipping from 56.7% to 53%, the lowest level since January. Overall, he dubs the report 'like a slow bleed for the labor market.'"

In all, there is not much if any good news in last Friday's employment report, yet the stock market had a nice gain.

The market is moving based on reported statistics as compared to expectations. This trend is accelerated by high frequency trading (HFT). If news is slightly better than expected, then various HFT programs kick in with the hope of making a small profit on many transactions as the market adjusts to news.

The market appears to consist of a consensus expectation from economists and financial analysts followed by an announcement exceeding or falling short of expectations, then a bout of HFC to take advantage of price movements. Nowhere in this cycle does fundamental, value, or technical analysis enter into the picture.

In my opinion, this is a dangerous situation that has few prospects for an acceptable outcome. Buying stocks is still a function of the business prospects for a company. Granted, expectations might give weight to future profits however the market functions best when there are many different sources of information and investors sort things out in a systematic way with an eye on returns. It seems the traditional, time tested approach to trading is very much out of vogue. This is nothing but trouble for stock prices as there exists little support for particular trades other than to capitalize on an small profit and then flip the stock, all occurring in microseconds or less.

HFT multiplied across the entire equity market, combined with the lack of fundamental, value, or technical analysis as the basis for stock trade, could trigger a run-up followed by a big decline.

It is ludicrous that purchases of anything, tangible or intangible, could be made based solely on performance relative to expectations.