The SEC Pursues a Fool’s Errand

u_s_sec_logo SEC

I imagine the SEC (or the Fed, IRS, or the FSOC) saying: “If we only have enough data, we can answer the policy questions that we are interested in, create better policy, prosecute bad guys, and regulate markets well.”

If they deigned to listen to an obscure quantitative analyst like me, I would tell them that it is much harder than that. Data is useless without context and interpretation. First, you have to have the right models of behavior, and understand the linkages between disparate markets. Neoclassical economics will not be helpful here, because we aren’t rational in the ways that the economists posit.

Second, in markets you often find that causation is a squirrelly concept, and difficult to prove statistically. Third, the question of right and wrong is a genuinely difficult one — what is acceptable behavior in markets? Do we run a market for “big boys” who understand that this is all “at your own risk,” or a market that protects the interests of smaller players at a cost to the larger players? Do we run a market that encourages volume, speed and efficiency, or one that avoids large movements in prices?

This article is an attempt to comment on the Wall Street Journal article on the SEC’s effort to create the Consolidated Audit Trail [CAT], in an effort to prevent future “flash crashes,” like the one we had five years ago. I don’t think the efforts of the SEC will work, and I don’t think the goal they are pursuing is a desirable one.

People take actions in the markets for a wide number of reasons. Some are hedging; some are investing; others are speculating. Some invest for long periods, and others for seconds, and every period in-between. Some are intermediaries, while others are direct investors. Some are in one market, while others are operating in many markets at once. Some react rapidly, and others trade little, if at all. Just seeing that one party bought or sold a given security tells you little about what is going on and why.

Following price momentum works as an investment strategy, until the volume of trading following momentum strategies gets too high. Then things go nuts. Actions that by themselves are innocent may add up to an event that is unexpected. After all, that is what dynamic hedging led to in 1987. There was no sinister cabal looking to drive the market down. And, because the event did not reflect any fundamental change to where valuations should be, price came back over time.

My contention is even with the huge amount of data, there will still be alternative theories, information that might be material excluded, and fuzziness over whether a given investment action was wrong or not.

After that, we can ask whether the proposed actions of the government provide any significant value to the market. Some are offended when markets move rapidly for seemingly no reason, because they lose money on orders placed in the market at that time. There is a much simpler, money saving solution to that close to home for each investor: DON’T USE MARKET ORDERS! Set the price levels for your orders carefully, knowing that you could get lifted/filled at the level.

This is basic stuff that many investors counsel regarding investing. If you use a market order you could get a price very different than what you anticipate, as I accidentally experienced in this tale. I could complain, but is the government supposed to protect us from our own neglect and stupidity? If we wanted that, there is no guarantee that we would end up with a better system. After all, when the government sets rules, it does not always do them intelligently.

One of the beauties of capitalism is that it enables intelligent responses as a society to gluts and shortages without having a lot of rules to insure that. Volatility is not a problem in the long run for a capitalist society.

If you lose money in the short run due to market volatility, no one told you that you had to trade that day. Illogical market behavior, as in 1987 or the “flash crash” could be waited out with few ill effects. Most of the difficulties inherent in a flash crash could be solved by people taking a longer view of the markets, and thinking like businessmen.

“It’s Baseball, Mom.”

I often spend time watching two of my younger children play basketball, baseball and softball. They are often in situations where they might get hurt. In those situations, after an accident, my wife gets antsy, while I watch to see if a rare severe injury has happened. My wife asked one of my sons, “Don’t you worry about getting hurt?” His response was, “It’s Baseball, Mom. If you don’t get hurt every now and then, you aren’t playing hard enough.” That didn’t put her at ease, but she understood, and accepted it.

In that same sense, I can tell you now that regardless of what the SEC does, there will be accidents, market events, and violent movements. There will be people that complain that they lost money due to unfair behavior. This is all a part of the broader “game” of the markets, which no one is required to play. You can take the markets on your own terms and trade rarely, and guess what — you will likely do better than most, and avoid short-term volatility.

The SEC can decide what it wants to do with its scarce resources. Is this the best use for the good of small investors? I can think of many other lower cost ways to improve things… even just hiring more attorneys to prosecute cases, because most of the true problems the SEC faces are not problems of knowledge, but problems of the will to act and bear the political fallout for doing so. And that — is a different game of baseball.




About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.