October 17, 2023
I have begun to write a book called “Delusional Capitalism.” It’s about how certain elements of capitalism are driven by unrealistic beliefs or misconceptions that have negative consequences. Take, for example, the practice of price discovery, a concept we have long believed is the basis of capital markets.
Price discovery was once a balance between the intrinsic value of a company’s assets and the internal and external risks of the company. But computer bots today control the market prices of exchange-traded funds (ETFs) whose components include both financially sound, rapidly growing companies and financially weak, operationally declining, and failing companies. I call them the good, the bad, and the ugly. The only reason independent investors support these bad and ugly losers is that Wall Street uses the ETFs as tools to control the allocation of investor capital into unacceptable levels of risk, using the misleading and laughable moniker risk diversification.
As many know, I continue to highlight serious problems in our financial markets, including the impact of computer bots and algorithmic trading on the price discovery process, particularly in the context of exchange-traded funds (ETFs). ETFs encompass a diverse range in the quality of companies, including strong performers and struggling entities. Unfortunately, this dynamic has altered the traditional balance between intrinsic value, risk assessment, and market price determination. Wall Street is taking advantage.
Understanding the implications of this shift away from investing in known entities and considering measures to address the associated challenges is crucial.
Here are some key points to consider:
- Algorithmic Trading and ETFs: ETFs have gained popularity due to their ability to provide diversified exposure to a basket of assets, but the basket includes strong and weak companies. The trading of ETFs is heavily influenced by algorithmic strategies that do not reflect the fundamental value of individual assets within the ETF.
- Market Efficiency: Traditional theories of market efficiency assume that prices reflect all available information, including the intrinsic value of assets. However, algorithmic trading deviates from this principle by introducing short-term price movements driven entirely by trading algorithms and fabricated market sentiment. Is it any wonder we call the market a casino?
- Short-Term vs. Long-Term Focus: Algorithmic trading operates on very short time horizons, resulting in price movements that are disconnected from the long-term fundamentals of the underlying assets.
- Investor Risk: Independent investors face the risk of capital loss due to detached short-term price movements on their investment decisions and portfolios that should be long-term based.
- Trader Risk: Opportunities perceived by short-term traders are traps set by the owner-operators of quantum computer-based trading algorithms that continually strip small, independent traders of their funds. Individuals can no longer outperform computers. Moreover, Wall Street’s computers are generations of next-level technology beyond our computers.
- Education: Financial journalists and independent investors should know the dynamics at play in ETFs and the influence of algorithmic trading. Investors must understand better the distinctions between short-term price movements and the long-term health of the companies in the ETFs.
- Regulatory Oversight: Regulators must ensure the integrity and stability of financial markets by implementing new rules and safeguards to address algorithmic trading, market manipulation, naked short-selling, and transparency issues.
In summary, the ascent of ETFs and algorithmic trading are connected. Together, they have transformed the price determination process in capital markets, leading to significant disparities between market prices and the underlying asset values. Immediate regulatory intervention is imperative to re-establish the fundamental role of price discovery in market dynamics. Because of the importance of this issue, it is crucial for financial journalists to approach the subject with greater impartiality and integrity, steering clear of biased endorsements for the sell side. In addition, promoting stock market literacy among investors is pivotal. Without essential knowledge, there is a growing risk of public disengagement from capital markets, potentially prompting governmental mandates for participation, like controlling our pension funds for purposes like ESG, inclusivity, and climate change, which can have far-reaching implications.
