Barrons ran a piece (http://online.barrons.com/article/SB126783128753256821.html) on the dangers of high frequency trading.  Here are some excerpts:

“HFT takes advantage of stock-price movements for short-term gain for one set of investment banks’ clients, while other clients are investing for the long term. These misaligned interests add to concerns about trust and integrity on Wall Street.”

“HFT players are now the backbone of the stock market, displacing traditional market makers in providing liquidity and contributing to efficient pricing. Yet unlike registered broker-dealers, many HFT players aren’t regulated or committed to the capital requirements for market-making in particular stocks. Many are effectively unregistered “shadow” market makers, with no commitment to maintaining a fair and orderly market.”

“In periods of turbulence, HFT traders can close out positions and leave the market at any moment, draining it of liquidity.”

“No one knows how deep, broad and lasting the decline would be if the liquidity powering much of the current market volume were to disappear suddenly. But the continued rapid growth, abnormally high profits, unmonitored leverage and misalignment of incentives make the HFT phenomena all the more likely to be the next source of systemic risk.”

“Machines have no emotions, but they can inflict more damage than temporary human panic.”

We mark the one year anniversary of the bull market tomorrow but many investors have missed out on this tremendous rally.  This is evidenced by the lack of inflows into domestic equity markets (in fact, there have mostly been outflows for the last year).  So, ask yourself, what powers this rally?  Is the rally being fueled by gap up openings which are fueled by overnight futures buying based on very little positive news?  The equity market has time and time again demonstrated the same daily pattern.  Quick morning ramps followed by dull, lifeless trading for the remainder of the day.  If most of the volume that we see today is not based on long term fundamental investors but rather short term scalpers looking to make a few pennies per share (a few million times a day), then the daily pattern that we see is understandable.  The theory goes like this:  get long in the first hour of trading, lever up this long position as much as you can, begin selling that long position slowly throughout the rest of the day.  But who would be the buyers you ask?  Liquidity rebate traders and institutional algorithms that are just chasing performance.

This is a vicious cycle that is causing much consternation among many professional investors.  They just can’t reconcile their dismal, long term economic view with the bullish, fast money trading patterns.  What breaks this cycle?  We wish we could tell you when and how but nobody knows.  Most likely the break will come with some unforeseen global event that causes margin calls on highly levered positions that will have to then deleverage.  Then, the liquidity that many investors believe exists in the equity market will most likely disappear.  And, those long term investors and late-to-the-game retail investors will be left holding the bag.