Contrarian Investment Strategies

by David Dreman

  As we have seen, the long-term returns of holding contrarian stocks through bull and bear markets are breathtaking; the longer the period, the more impressive the results. We will shortly provide some impressive evidence that owning stocks has been one of the two best ways to go, not only for the past decade but for the past two hundred years.

  Chapter 13

  Investing in a New, Alien World

  TODAY’S INVESTMENT WORLD seems as foreign to many as being encased in a spacesuit on a meteoroid. Through the suit you can hear the hissing of fissures and somewhere farther away the explosion of meteorites crashing into rocks. Craters whose depth is impossible to gauge in the semidarkness seem dangerously close. The only light is from Earth, which seems very large but impossibly far away. If you walk too vigorously, you may catapult into a crater or onto a jagged peak because there is almost no gravity. In short, welcome: this is the investment world many people feel they are in today.

  The investment arena is a disjointed, difficult world far different from the one we approached so enthusiastically only a little over a decade ago. Here we’ll look at a set of particularly important new threats and how you can cope with them as well as the new opportunities available now.

  Most of the rules of investing that we were taught, and thought we had mastered, at times seem altered and unfamiliar. Now we face high volatility, flash crashes, an economy only just crawling back after the Great Recession, derivatives so complex that even major institutions such as AIG have imploded using them, and stock and bond markets that often seem dysfunctional. We’ll have to be at our intrepid best to adjust to the conditions of investing in this altered and unfamiliar investment environment.

  The Flash Crash and the August 2011 Panic

  E-world technologies make possible market strategies that were never practicable before, but some of the results can have all the characteristics of a major crash—only it all happens so much faster. On May 6, 2010, out of nowhere, the Dow Jones Industrial Average dropped 9.2 percent. This was its biggest tumble since the 1987 crash: $862 billion in U.S. stocks were erased in less than ten minutes. Although the worst trades were canceled and the markets pared back the decline to 3.2 percent at the close, investors still took major losses that day. Worse, their confidence, already badly battered by the crash of 2007–2008, was further rattled by what was soon dubbed the “flash crash.” The report the SEC and the Commodity Futures Trading Commission (SEC-CFTC) released on the crash on September 30, 2010, appears to have only scratched the surface of the problem. To date, the SEC has continued to move in a slow but methodical manner. Many professionals knowledgeable about the flash crash worry that the SEC’s reaction was far too slow, as it was in 1987, opening up the possibility that a far more severe crash could be in the wings.

  What has not been analyzed to date is the effect of a giant new force in the stock market called high-frequency trading (HFT). The best of the traders who use these methods have built trading systems that move almost in milliseconds (thousandths of a second) to almost instantaneously get a slight advantage in any trading patterns their computers spot. The profit is only a fraction of a penny per share in most cases, but the volume of trades is enormous. Although precise figures are elusive, some trade sources estimated that by mid-2009, high-frequency trading accounted for almost 75 percent of the volume on all U.S. markets, up from 33 percent in 2006 and only about 10 percent in the early years of the last decade. Despite their huge trading volume, HFT firms represent only 2 percent of the approximately 20,000 brokerage firms operating in the United States today.1

  High-frequency trading firms are made up primarily of scientists, software developers, math whizzes, and information technology developers whose mission is to squeeze out a fraction of a penny in profits per share on each of these trades. At RGM Advisors, a major high-frequency trader in Austin, stone urns in the lobby are stuffed with pennies as a reminder that the firm trades hundred of millions of shares a day, for well under a penny profit apiece, and makes money doing it. High-frequency firms such as RGM are a driving new force in the U.S. securities markets. Speed is king; even millionths of a second can make a big difference.

  High-frequency traders have set up headquarters from Chicago and Austin to Red Bank, New Jersey. Algorithms, enormously fast computers, and direct cables that transfer data almost at the speed of light give them a precious few milliseconds of advantage. Using their enormous speed, they scour public and private markets for deviations from historical price relationships between stocks and jump on discrepancies, rather than playing the stocks themselves. They also use puts, calls, or futures when they work.

  The burgeoning HFT industry has spawned legions of jeans-wearing techies who arm their machines to outwit rivals. Programmers write formulas to sniff out the buy and sell intentions of mutual funds and jump in ahead of them in a practice called “gaming.” HFT firms also employ strategies such as iceberging, breaking a single large order into chunks and leaving just a small order, or the tip, visible. The gamers, also called sharks, place small buy and sell orders to uncover the hidden larger ones, which they then front-run.

  High-frequency trading played a large role in the ten-minute U.S. market crash on May 6. The automatic execution of the sale of futures contracts valued at about $4.1 billion on the Chicago Mercantile Exchange played a major part in triggering the plunge, according to the joint SEC-CFTC report. The initial sales of the contracts led to a burst of trading among HFT firms, the report added.2

  The SEC-CFTC report indicated that the market was already down 3 percent that day, when Waddell & Reed, a major Kansas mutual fund complex, put in an order to execute 75,000 mini E contracts*70 of the S&P 500 as a “routine hedge” transaction. Despite Waddell & Reed’s protest, the transaction was anything but routine. It was carried out for its most aggressive, free-swinging mutual fund, which accounted for more than 15 percent of its assets. Although the order was supposedly put out carefully, high-frequency traders and a few brokerage firms played a major role in driving prices down. Critical to the debacle was that they stopped buying and started selling futures as S&P minifutures plummeted, putting more pressure on the downward-spiraling prices. Brokers, through various sophisticated techniques, reduced their executions of clients’ sell orders, which they normally took the other side of, but continued to execute buy orders. This in effect allowed the brokers and market makers to sell their own inventory to their customers and get shorter.

  The lack of liquidity was major. The next day, the regulators and the exchanges reversed some of the trades, but the reversals were only for trades that had taken place at 60 percent or lower than pre–flash crash price levels.

  The damage to investors was serious. Twenty thousand trades, totaling 5.5 million shares, executed 60 percent or more below the pre–flash crash price, were canceled. At least half of those were retail orders. And that does not include the far larger number of trades that were executed at a steep discount to the precrash level that were not canceled.3 What caused the regulators’ overly timid actions?

  For investors to lose 60 percent of their stocks’ value in minutes is unheard of. Since this crash, circuit breakers*71 have been posted for various categories of trades. If the market rises or drops by a predetermined amount, the circuit breakers kick in, allowing various stocks to move from 3 to 15 percent for the NASDAQ 100, depending on the stock price, 10 percent for most large listed stocks, and additional limits for the Dow Jones Industrial Average and other indices. The circuit breakers at this time are extremely complex and vary widely for different stocks and markets.

  Why did the regulators, only months before, let individual investors take losses as high as nearly 60 percent—up to as high as twenty times the amount of the new limits? That question has never been answered. Surprisingly—or perhaps not—the only ones who could make money from the original flash crash were the high-frequency traders and a handful of brokers.

  Unfortunately once again, we see our exchanges
and regulatory agencies at work. Who benefits from crashes: small investors and mutual funds or the flash traders and hedge funds that feed on them? The question is rhetorical. The institutions and small investors were taken out by the bottom-feeders as the regulators looked the other way. Does this remind you of another crash not much earlier?

  This crash may be only the tip of the iceberg. The question is asked more frequently whether rather than providing liquidity at the most critical times, as the HFT crowd strongly claims it does, HFT actually drains liquidity. The initial SEC-CFTC report written after the flash crash on May 18, 2010, contradicts the high-frequency traders’ assertions, stating that “preliminary analysis shows that between 2:30 p.m. and 3:00 p.m., trading volume spiked, bid/offer spreads widened, and depth declined. The latter two observations are consistent with a significant decline in liquidity with the bulk of that decline occurring between 2:42 p.m. and 2:45 p.m.”4 The SEC-CFTC report further comments, “During the 30-minute period from 2:30 p.m. to 3:00 p.m., trading volume was about 10 times the average daily trading volume for the same intraday time period calculated over the prior 30 days.”5 The report states that the heaviest trading occurred after liquidity dried up in the critical 2:42 to 2:45 P.M. time period.

  The S&P 500 futures did not provide additional liquidity, as virtually all the high-frequency traders claim; they actually decreased liquidity in much the same manner as in the 1987 crash. Heavy short selling slammed prices downward. When panic is created, the standard operating procedure of the short sellers is to stand aside as prices plummet, reappearing only when buyers begin to come back. This creates big-time profits for the high-frequency traders. And it was all made in the U.S.A.

  Insiders knowledgeable about HFT suggest that there are many similarities between these events and the price drops prior to the 1987 crash. On this basis alone, HFT is not a boon to liquidity but a serious danger to the destabilization of the market, with the risk of possibly triggering another 1987-type crash.

  Other Potential HFT Problems

  Unfortunately, the danger does not end there. According to a report in Bloomberg News, Nanex, a data firm located in Winnetka, Illinois, says that some activities are definitely underhanded. Its researchers have found instances in which thousands of quotes a second in a particular stock are fired and canceled almost instantaneously, overwhelming trading systems.6 This process has added the term “quote stuffing” to the lexicon. “High-frequency traders are not interested in the fundamental worth of a company,” says George Feiger, the CEO of Contango Capital Advisors, a San Francisco money management firm with $2 billion in assets. “They are only interested in making a quick killing and moving on.”

  Regulators are struggling to find solutions for reining in the HFT crowd and its computers. The SEC is looking into establishing and then enforcing a minimum time period, such as fifty milliseconds, in which a quote to buy or sell a stock would remain valid, according to firms that have met with the agency. The SEC is also considering whether to require high-frequency firms to remain in a market, rather than pulling out when times get tough, to maintain liquidity, which is after all their primary function.

  Ted Kaufman, at the time a senator from Delaware, proposed a number of protective measures that would limit the damage of plummeting S&P futures. He wanted the SEC to limit the number of quote cancellations. The agency has proposed rules to monitor firms that trade more than two million shares a day.

  However, such changes assume that enforcers are as agile as the high-frequency firms. “‘Technological advances have outstripped our ability to regulate them,’ says Andrew Lo, director of Massachusetts Institute of Technology’s Laboratory for Financial Engineering and chief scientific officer of quantitative-analysis hedge fund AlphaSimplex Group. ‘It’s like the Wild Wild West.’”7

  HFT 2: The Guns of August

  Through the end of 2010 and continuing in 2011, as we saw, the SEC and the Exchanges put in circuit breakers and limits that determined how much a futures index or stock could fall or rise in a given period of time. The SEC also continued its investigation of the flash crash and subpoenaed firms that do high-frequency trading.

  Although there appeared to be widespread skepticism that high-frequency trading was under control, the regulators allowed it to continue with the curbs that had been put on it, as the investigation continued. Volatility stayed very low and stock prices were rising. The SEC and other regulatory bodies’ investigations dragged on at a snail’s pace.

  Then things began to change. On July 27, 2011, the S&P 500 dropped 27 points, or 2 percent. For that month as a whole, though, the S&P was down only slightly (2.1 percent), volatility was still very low and the correction was minor relative to the market’s major rise for 2009–2011. But moving into August, the roof began to fall in. After declining moderately on August 1 the S&P plummeted 33 points, or 2.6 percent, on August 2, and suffered an enormous 60-point drop, or 4.8 percent, on August 4, followed by a drop of 80 points, or 6.7 percent, on the eighth. The Dow Jones, meanwhile, plummeted 635 points on the eighth. From July 8 through August 8 the S&P had fallen 17.3 percent—13.4 percent in the first six trading days of August alone—and was on the doorstep of a new bear market (considered a drop of 20 percent or more).

  Volatility skyrocketed. The VIX volatility index traded on the Chicago Board Options Exchange (CBOE), also known as the “fear index,” measures the implied volatility for the S&P 500 Index options. The lower the VIX, the more confidence people have that markets will not move up or down rapidly. For the previous eighteen months through July the VIX normally traded around 20, which is considered a low-volatility level. Then a tidal wave of fear swept through markets.

  The S&P 500 cratered as the VIX soared. In a matter of days the VIX index doubled. From 16 in early July it began to move up and by early August it took off. From 32 on August 4 it rose to 48 on August 8, a rise in volatility almost never seen this quickly, even in a free-falling market. Panic was everywhere spurred on by the enormous volatility. Global markets, taking their cue from the United States, dropped as much and in many cases more than the domestic ones.

  Over three trillion dollars had been lost by investors and institutions domestically, the great bulk in less than three weeks. The rush out of stocks was like a panic at the exit in a theater fire. In the four months ending in mid-September investors had pulled $75 billion out of U.S. stock funds, more than in the five months after the collapse of Lehman Brothers.8 Meanwhile, gold and almost-zero yielding treasuries rocketed upwards. Investors globally yanked $92 billion from stock funds in the three months through the end of August, which was more than the total moved into stock funds from the spring of 2009, when the market rally began.

  Fear turned into contagion among investors. Many sold at any price, thinking that after the twenty-seven-month rally following the 2007–2008 crash, stocks were heading down to major new lows. The falling prices and volatility continued to the time of this writing in early October.

  Inflows to some banks were so high that a number of them, including Bank of New York, announced they would post fees to take in new deposits for large accounts, something almost never done before. How did this all come about?

  While the thick smoke from this battlefield has not cleared and likely won’t for many months, the regulators and experts are increasingly focusing on high-frequency trading as one of the chief culprits. HFT trading tripled during this period and was the dominant force in U.S. markets. According to a report in The Wall Street Journal, the market research firm Tabb Group estimated that the increase in the volume of HFT trades in August brought their share of total U.S. stock trading volume to 65 percent from 53 percent in the prior months.

  Volume including HFT was up 80 percent, indicating that these firms were on a highly profitable trading tear during this period, while most other investors suffered substantial losses. The overall volume of equity trades between August 4 and August 10 averaged 16.0 billion shares daily, the busiest five
days of trading on record. The report further states that the volume of trading was especially high on August 8, with the Dow dropping 635 points—making it the fourth busiest trading day on record—and Tabb estimated that HFT traders made approximately $60 million in trades in U.S. stocks and futures that day. Profits ranged from $40 million to $56 million on other days of that same week.

  The article cites a number of firms that made large gains, pointing out that August 8 and 9 were both big winning days for Tradeworx Inc. of Red Bank, New Jersey. Getco LLC, based in Chicago, was also a big winner. And hedge fund Renaissance Technologies LLC of East Setauket, New York, was said to have earned total gains of $200 million in the first two weeks of August in two funds it manages.

  To provide a comparison, the article states that Tabb estimates that the profits from HFT in stocks for all of 2009 were $7.2 billion. HFT traders are also active in stock futures and in major commodities such as oil and gold, among other markets. The large high-frequency profits came as other stock buyers including some major hedge funds, mutual funds, and individual investors were badly bruised. Adam Sussman, director of research at Tabb, said in the article that “Retail investors are just going nuts, and high-frequency traders are feeding off the volume.”9