The Fox In The Henhouse?

October 20, 2008

Are the Magnificent Seven making legitimate, coherent arguments for investors or are they another fox in the market henhouse?


I've spent a good bit of time talking to Dan McCabe and the Next Investments guys. And I think they're smart guys, are very knowledgeable about trading and are fundamentally good guys as well. But does what they're saying in the guest blog posted here last week make sense?

First, let me list out as crisply as possible what I think their key points are (and you can read some of these in more detail in their recent MarketWatch feature):

  1. Markets need some kind of interference, through specialist or slower trading to dial down volatility.
  2. The share-lending market is opaque and investors are not tuned in to the risk they're taking with those markets, which are operated not with investor interests in mind.
  3. The compensation structure for corporate leadership is fundamentally flawed and encourages highly risky behavior with little downside for leadership when things go wrong.
  4. The interests of the U.S. economy and corporate America are much better aligned with those of LONG TERM than with those of traders.

From an investor perspective, it's hard to disagree with numbers 2, 3 and 4. Those issues seem blazingly clear in the spotlight of all of the recent scandals and turmoil. Hopefully, sensible market reforms from within and without will address all of those problems.

The Trading Issue

The BIG question is whether accelerated trading activity, more speed and tighter pricing (in effect, custom fitting markets for traders like the Next guys say) IS really harming investors by bringing more volatility (which generally tends to mean more downward price pressure in times of crises, and generally less stability and long-term focus on fundamentals long term).

To Dan, the answer is reflected in the last 2 or 3 weeks, and is an obvious "yes," The Magnificent Seven genuinely believe that large traders have been able to effectively manipulate markets by pushing up volatility and accelerating price movements in the markets. Fundamentally, I DO like best pricing and tighter spreads, which is what more electronic trading has brought to markets (though I'm NOT a big fan of wild volatility).

And I do think that back in the day, specialists WERE able to make large sums of money on spreads that were often a mile wide. Obviously those days are over. The question is, do we trust the Magnificent Seven on the spreads issue because they as former traders understand those issues better than anyone else can, or NOT trust them because they come from a perspective (as former specialists) that is opposed to much of the move in markets toward fully electronic trading?

You be the judge.

TED Spread Plummets

Meanwhile, the week opens with big, positive news. For those of you who have followed these blogs and follow finance, you understand the TED spread (the difference between the three-month T-bill interest rate and three-month LIBOR—interbank dollar loans). Well as of this morning, it's down to 3.27%, from over 4.5% at one point, as the LIBOR rate has dropped to 4.06% from 4.42% just late last week. A quick read of the data shows that the 3-month dollar LIBOR rate has varied from around 2.5% this year up to 4.8% recently, and we have not seen anything as low as this morning's 4.06% rate since late September. So it appears that the governments are doing something right. And this is a great sign, and a big movement.



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