Market Overview

Defending The Indefensible: Flash Trading Helped Save the Stock Market

In his latest book, Flash Boys, Michael Lewis contends the stock market is "rigged" in favor of institutional investors who buy and sell securities rapidly with computer programs, booking loads of tiny profits.

This is at the expense of the individual investor, Lewis claims. Actually, it is the individual investor who has benefitted the most from the trading of high-frequency-traders (HFTs).

American wealth is now at an all-time high, in large part due to the stock market being at record levels.

That is the gain of those invested in the stock market. But the percentage of Americans owning stock is at its lowest level since 1998. It is the institutions such as HFTs that have powered the tripling of the Dow Jones Industrial Average over the past five years.

Related: 3 Small Caps With Star Power

The American economy owes a large part of its recovery from the Great Recession to HFTs, a major component of then-Federal Reserve Chairman Ben Bernanke's grand design. In an article in the Washington Post on Nov. 4, 2010, Bernanke wrote that "higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

High levels of liquidity, like those brought to equities by HFTs, are what makes for a healthy market for any asset class -- according to billionaire investor Sam Zell in his remarks at the "Invest for Kids" conference last October.

Flash trading brings in huge amounts of needed liquidity to the financial markets. The only way that any asset ever rises in value is the willingness of the counter-party to pay a higher price, which results in increased liquidity.

These transactions also result in fees that improve the financial exchanges where the trades are executed, too.

That has obviously helped the Standard & Poor’s 500 Index achieve record levels, while performing well as a marketplace. But at the present price-to-earnings ratio of 19.84 it is hardly overvalued. That’s lower than it was in the first quarter of 2010, the first quarter of 2009, the first quarter of 2008, and lower in the first quarter of every year from 2005 back to 1997. Greater liquidity also results in more products, which means more choices in the asset class for investors.

Individual investors are better equipped now due to the resources expended by HFTs and other financial institutions.

"Barbaro" was a Kentucky Derby-winning horse that died after breaking his leg in the Preakness, the second race of The Triple Crown, in 2006. Having wealthy owners, Barbaro recieved very expensive treatment that few could have afforded put into saving another racehorse. But from those unsuccessful efforts, new methods were perfected for treating other horses.

The rich and the powerful like the owners of Barbaro, who owned minor league baseball teams, are the ones that can afford to experiment. Eventually, the gains will make it to the masses. That has certainly been the history of investing -- with, for example,  individuals now having access to computer software and hardware that once only big financial institutions could afford.

HFTs also serve to enhance the advantages of the long term investor.

Warren Buffett, the legendary investor who is worth over $50 billion, told Fortune that he learned more from owning See's Candies, a $25 million buy, than from his investment in large companies like Coca-Cola or ExxonMobil

"It's one thing to own stock in a Coca-Cola or something," Buffett said, "but when you're actually in the business of making determinations about opening stores and pricing decisions, you learn from it. We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me."

HFTs will never benefit from that like Buffett. Long term investors will, at the expense of HFTs who will miss the gains over time.

Small cap investors will prosper more when HFTs are active.

Due to the size of the transactions, flash traders cannot buy and sell thinly traded stocks without distorting the price. That can result in huge losses. This offers opportunities for investors to profit for the long term from the small cap sector and other thinly traded securities as a pure play without traders or speculators warping the efficient pricing of the asset. Long term investors here can profit from the efficient market theory in action, which renders a huge advantage over HFTs.

More needed attention is focused on dividend stocks by HFT trading.

According to Dom Einhorn, head of Born2invest, investors should only buy assets that pay them to be the owner. For stocks, that means owning those that pay dividends. As dividends are only paid four times a year, those dates are when HFTs will buy and sell to "capture the dividend," buying a stock solely for the dividend payment than selling it immediately.

That leaves the rest of the year for long term investors to buy when the share price falls, which makes the dividend yield even higher. This can be very lucrative over the long term, as detailed in a previous article on Benzinga.

It is difficult to see how the stock market would have recovered without the participation of HFTs and other institutions. The individual investor has backed away, which is to their loss. For those uncomfortable with individual stocks, there are many excellent mutual funds and index funds.

Without the rise in the stock market, the American recovery from the Great Recession would have been much more difficult, based on Bernanke's strategy.  As the Dow Jones Industrial Average has tripled since March 2009, individuals owning stocks have prospered greatly from the activities of HFTs and other institutional investors.

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