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The Three Volatility Boogeymen

07

September, 2011

A third boogeyman to the recent volatility in the stock market has just been named. In addition to high frequency trading and the lack of an uptick rule, leveraged ETF’s have been identified as a volatility culprit. The WSJ reports:

“U.S. securities regulators are looking into whether turbocharged exchange-traded funds amplified August’s topsy-turvy swings in the stock market. Securities and Exchange Commission officials have had discussions with firms that trade ETFs, asking questions about whether they added to the market’s volatility.”   Read Article here

No doubt that all three of these boogeymen have contributed to the excessive volatility of the past few weeks. But, we do find it a bit convenient, now that the market is under pressure, that the pitchforks are out and culprits are being sought. After all, these boogeymen are not new to the market and have been living inside this haunted house of a stock market even during the rally off the March ’09 lows. However, during market rallies, the boogeymen are contained and in fact may even add to the strength of a rally. In past posts, we have written about the HFT amplification effect and how it works in both up and down markets. Nobody seems to care about an uptick rule as long as the market is rallying. And when was the last time that you heard somebody complain that a three times leveraged bull ETF was driving the market higher.

The point is that the stock market has major structural deficiencies brought on by the consequences of years of regulations and the conflicted interests of major industry participants. By pointing to the boogeymen to deflect the structural deficiencies is similar to experiencing major chest pains and blaming the fast food lunch that you ate for the pains. As they say, “you can’t fix a problem unless you admit you have one first.” By identifying the boogeymen, at least market participants now realize there is a problem in the equity market. Now it’s time to fix that problem and not just by going after the boogeymen. We think it may be better to rebuild the entire haunted house (the stock market) where the boogeymen live.

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