Posted by Curt on 29 April, 2013 at 4:59 pm. 1 comment.


Tyler Durden @ Zero Hedge:

Capitalism may have bested communism a few decades ago, but exactly how our economic system allocates society’s scarce resources is now undergoing its first serious transformation since the NYSE’s founding fathers met under the buttonwood tree in 1792.  Technology, complexity and speed have already transformed how stocks trade; but As ConvergEx’s Nick Colas notes, the real question now is what role these forces will play in long-term capital formation and allocation.  Rookie mistakes like the Twitter hack flash crash might be easy to deride, but make no mistake, Colas reminds us: the changes that started with high frequency and algorithmic trading are just the first step to an entirely different process of determining stock prices.  The only serious challenge this metamorphosis will likely face is a notable crash of the still-developing system and resultant regulation back to more strictly human-based processes.

Last week’s Twitter hack and resultant mini-crash in U.S. stocks made for a few minutes of confusion and several days of humorous commentary.  It is, however, also a sign of the times.  That a system of communication where Justin Bieber, Lady Gaga and Katy Perry are the lead dogs could encroach on “Orderly and fair markets” should force some discussion of where U.S. stock markets are heading.  “I crashed the market and I liked it…” isn’t a top 40 song. Yet…

Let’s begin with a few basics about what role equity markets are supposed to play in a modern capitalist economic system:

  • Stock markets exist to determine the value of publicly held companies using all legally available information that may impact their future cash flows and strategic positions.  There are a lot of items on this menu of value drivers, from prevailing interest rates to the quality of a given management team.  The benefits to any individual or group of investors to predicting enough of these inputs correctly on a consistent basis are, of course, sizable.
  • The resulting prices are signals to the broader economic system about the ongoing value of the company’s business model.  Well-considered companies with high valuations can purchase the assets of laggard enterprises with low valuations and operate them better.  Poorly run businesses fail, freeing up society’s intellectual and physical capital to pursue better uses.  Private equity can purchase underperforming assets as well, hopefully to re-engineer the business and return some or all of it to better health.
  • Through the IPO process, equity markets allow promising enterprises to tap a large pool of capital that allows for further growth.  Once public, they can make acquisitions for stock and reward productive employees with real ownership in the business.
  • Stock grants to management in well-run businesses – old and new – can allow the operation to entice the best available intellectual capital to join the firm and maximize their focus while employed there.  This ideally allows society to ensure that the scarcest of all economic resources – people – flow to their best possible uses.
  • Stock prices provide valuable economic signals to society at large – labor, capital, government and all other economic actors.  This, by the way, is why the Federal Reserve and other central banks care so much about rising equity values.
  • Public ownership of private capital allows society to “Spread the wealth around” through the individual ownership of equity assets.  Individuals can buy diversified portfolios of public companies and earn returns on their capital that mirror the trends in return on investment capital for the businesses they own.
  • Yes, I know it’s fashionable to pick apart these idealistic characteristics at the moment.  At the same time, free market capitalism has a reasonable track record over history for improving the lives of large chunks of the human race.  So until we get a race of incorruptible philosopher-kings in the mix, this structure is the best thing going.

The Twitter hack is the most notable example of “How” this process has changed, specifically in the real-time valuation of U.S. stocks.  To understand where we are, you first need to parse out the important changes that have occurred in stock trading over the last +10 years.  Over that period, market structure moved from having one dominant exchange for a given stock (IBM on the New York Stock Exchange, Microsoft on the NASDAQ) to a highly fragmented system of multiple “exchanges” – pools of buy and sell orders managed by very fast computers.

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