Monday, April 1, 2013

Avoiding The Light

Readers know my expectation is the U.S. economy will continue to improve:  faster with help from Washington and slower without it.  However, we are increasingly vulnerable to a "Jim Fixx moment," recalling the father of running who suddenly dropped dead while running in his neighborhood, despite having a long body-mass index.

The most likely event that might trigger this heart attack is a derivatives blow-up.  Nobody is certain how big the problem is or, more importantly, who will end up holding-the-bag after the blow-up.  When this happens, it will happen suddenly,

Secondarily, the complex technology systems used to trade can still breakdown.  Remember that awful day  on May 6th, 2010 when the Dow suddenly lost almost a thousand points in twenty minutes, due to computer problems.  While it recovered quickly, what if it didn't?    Does high-speed trading (HST) make this scenario more likely and suddenly?  Of course, it does.

Third, I'm increasingly concerned about the "dark pools," which are those thirty unregulated exchanges run mostly by large banks among its customers.  Suppose a large pension fund wants to sell a million shares of Apple without any prior notification and causing the price to fall.  They contact their local bank who arranges the sale to another customer.  There is nothing illegal about that.  But, isn't that information important to the market?  How about if somebody is building a position to take control of a company, whose stock you own?  It is an unlit market.  The New York Stock Exchange is a lit market, where investors see what other investors are doing.

Here is the problem:  "dark pools" are growing.  In 2009, only 18% of all stock trades were hidden.  Today, it is approaching 40%.  In other words, the portion of stock trading taking place in secrecy and without regulation has doubled in just four years.  Soon, half the trading will be without regulation and in the dark.

Does that mean we should avoid investing in the improving U.S. economy?  No, but it does mean we should have a clearly defined "sell strategy," which clearly identifies events that will trigger a sale.

The next time you are taking a run through your neighborhood, think about developing your sell strategy.