The New Rules of Investing

Why is the market so schizophrenic? Computer-driven trades and investors focused on short-term moves have changed the game

Based on the way higher oil prices whacked the stock market Aug. 4, you might think crude had popped by $5 a barrel. The Dow Jones industrial average plummeted 163 points that day, in a move largely attributed to light sweet crude reaching a record high of $44.41 a barrel in the cash market.

The truth, however, is that oil had been trading right around $44 all week. Sure, that's high. But the dramatic one-day drop in the stock market had more to do with the fact that many large institutional investors programmed their computers to sell stocks when oil climbed above $44, observes Larry Peruzzi, a trader at The Boston Company Asset Management.

"Does it seem rational that stocks would perform poorly if oil continues to climb? Yes," says Peruzzi. "But does it seem rational that an arbitrary number would have such an impact? No." A few months ago, $37 was triggering program trades, he noted. "Now $44 is the magic number."


  Welcome to the new world of investing. As buy-and-hold investors watch from the sidelines and hedge funds using complex algorithms to predict market moves proliferate, the market has become increasingly computer-driven, focused on the short-term, and highly speculative (see BW Online, 8/6/04, ).

"There's a greater element of speed -- faster communications, faster execution, faster decision-making," says Michael Panzner, a trader at Rabo Securities and author of The New Laws of the Stock Market Jungle. "There's more noise and more false moves."

The long-term investor who checks in occasionally to see what's going on can be alarmed by what's happening. Technical indicators, like the level an index reaches on a analytical chart, can trigger major buying activity, even if there was no positive fundamental news in a particular sector. For example, one reason financial stocks rallied on Aug. 2 in the wake of a government announcement of a new terrorist threat may simply be because, that same morning, they fell to a technical level at which a lot of buyers had decided weeks ago to buy. So while most investors might have expected stock prices to decline in the face of rising fear, they actually rose. Go figure.

Similarly, individual stocks' moves can seem inexplicable until examined in the context of today's trading strategies. Did you wonder why Citigroup (C ) rose the day after its New York headquarters was named as a terrorist target? It may simply be because it was bought that day as part of a basket of bank stocks (see BW Online, 8/6/04, "Hedge Funds Are Everyone's Problem").


  Program trades, in which institutional investors buy a basket of stocks all at once, is increasingly the name of the game. Then, in a phenomenon Panzner calls "the tail wagging the dog," if traders learn a large institution has put on a huge trade on a basket of stocks, they may all pile on, creating a self-fulfilling prophecy.

Conventional wisdom can be turned upside down in this high-speed investing environment. Ten years ago, you could buy your favorite stock right after a positive earnings announcement and expect to see the shares jump that day.

"That game has been totally arbitraged away," says Greg Forsythe, director of Schwab's Equity Ratings division. Now, a high-flying stock is likely to run up ahead of an earnings release and sell off after, even if it meets estimates. "People feel like they have to act even earlier in anticipation of events," says Panzner. "It's almost like a remote-control market."

One reason for the short-term focus is that investors, still smarting from the long bear market that followed the stock-market bubble, want to lock in profits as soon as possible. Stocks can swing wildly as momentum investors buy on the way up and sell on the slightest dip, say investment strategists.


  In the old days, portfolio managers would buy or sell a stock slowly, over weeks at a time, testing their theory along the way and gaining confidence in the decision. Now, as Panzner notes, they order up trades using phrases like, "I want to be done" -- meaning, execute the whole move immediately.

In this context, investors can seem to completely ignore important long-term trends -- like the fourth consecutive quarter of 20% plus earnings gains in the S&P 500, which were still being reported out as the market fell on Aug. 5.

One reason the market hasn't sustained a rally this year, believes David Hagerty, head equity trader for Commerzbank Securities, is that hedge-fund investors have used any increase in stocks to short the market. "They are shorting into rallies," he says, "leaning on the market any chance they get."


  Hagerty, for one, doesn't think there's a problem with the huge volume of trades being ordered up by computer programs. He says those "black boxes" often have the benefit of slicing up large orders, parceling them out so they create less volatility in stocks.

Even if they make quick decisions that may seem counterintuitive in the short term, most of today's investing pros are still at work trying to predict the future direction of the economy and stock prices. That's a game where individual investors with a buy-and-hold strategy may ultimately beat the biggest players, even without the supposed benefit of sophisticated stock charts, computer algorithms, and instantaneous program trades.

To build and maintain a healthy and stable portfolio, avoiding those sweeping, computer-driven swings is vital -- something that's a lot easier said than done.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

Edited by Beth Belton

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