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What's Causing the Huge Stock Market Swings

What's Causing the Huge Stock Market Swings

And Should the Average Investor be Involved?

For as long as I have participated in the global financial markets, now surpassing 40 years, I have been a proponent of "market solutions" to any problems or perceived problems as far as the behavior or the structure of the market was concerned. Governmental regulatory solutions to such problems over the years have proved burdensome, restrictive, and at times anti competitive, particularly in the United States. Over the last several years, since the huge market meltdown triggered by the mortgage crisis and excessively easy lending policies, the global equity markets have taken on a new look. I'm not so sure that the new look has been or will be beneficial to the majority of individual investors, and I'm not so sure the market can sort out the problems on its own.

Almost all of the order flow, the buys and the sells on all of the individual shares, has become mechanized. Even very small investors now have access to most markets with extreme speed and accuracy using only their personal computers and now even their smart phones and tablet computers. While on the surface this has been a good result of technology applied to market mechanics, reducing costs and broadening access, it is now clear that large trading entities have the capital and technical capacity to blow away the small investor in these markets using even more sophisticated technology and systems unavailable to the individual.

Large investment banks (the Wall Street giants that have become household names) and large hedge funds (entities which have amassed large sums of capital from high net worth individuals, pension funds, and money managers, which they systematically invest), today have the technical expertise and the millions of dollars worth of computing equipment and software to drown the small investor with the push of a button. Because there has been an elevation of the level of fear surrounding the market, market volatility has increased substantially. Volatility is a measure of the price behavior of the market. The very radical and wide swings in price which we have witnessed over the last couple of years is the result of this increased volatility.

The large investment banks and hedge funds can exacerbate this volatility by a practice known as "high frequency trading." As the words imply, these large trading entities place orders for tens of thousands of shares in a single company, either to buy or to sell, and they swiftly move the market price to different levels. Often, their initial activity will be followed by many others attempting to emulate the trade, which tends to press prices even further away from the "true value." Then, just as quickly, sometimes within minutes or even seconds, the entity reverses its original position and liquidates the shares. These actions may only result in a few pennies per share in profit, but because of the huge volumes they trade they are well rewarded for a few moments efforts.

The fallout of this type of activity has been to cause a great deal of confusion and uncertainty as to the value of various shares, momentarily or over a period of time, which in turn fuels even greater volatility and risk to the long term investor. The current circumstances surrounding this type of high frequency trading and the damaging effects it may cause warrant a closer look by regulators, as the market has not yet been able to sort these issues out on its own. Those readers who have been able to attend one of my work shop presentations in Vernon Hills or elsewhere will be familiar with some of what I have discussed herein. As individuals attempt to plan for and direct their own financial futures, it is likely that investments in equities will play a role in those efforts. To the extent that we invest in shares, we want to have some assurances that our investments will perform primarily according to the successes or failures of the company in which we invest, and not as a result of artificial price distortion resulting from some of the practices associated with technology and huge sums of capital.

I don't advise side stepping the opportunity to add good quality equities to your investment approach, however it is important to be aware of the new risks associated with those investments so that you can plan accordingly. I have frequently suggested the use of professional advice in building your financial security, and I would reiterate that suggestion in the face of the new trends in trading which have adversely impacted the returns on many portfolios. BCU Investment Advisors is a good place to start for BCU members, or seek outside assistance through referrals from friends or relatives to a certified financial planner or licensed investment advisor. Remember, there are always opportunities in the market; frequently we can capitalize best on those opportunities with the assistance of qualified advisors. As you review your personal financial picture as 2011 draws to a close, consider where professional advice may have made a difference in your results and take the time to lay out your plans for 2012.

©Patrick J. Catania 2010
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.

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