Rigged Markets Have Driven Out Retail Investors

"You could buy and hold a company for 15 years and then have everything you've built up disappear in five minutes. No one can take that kind of risk anymore. There's no such thing as a widows-and-orphans stock anymore." — Professor Perry Glasser, in the Wall St. Journal

Over the past few years, a series of alarming incidents and events have eroded — if not completely destroyed — the average investor's trust in the stock markets. This is a critical development since markets are founded on trust, and they don't function very well without it.

Historically, transparent markets helped raise capital, build business and create jobs. But that system, which had worked fairly well for more than a century, has been jeopardized by recent events.

Most of them have been caused by high-frequency trading, in which supercomputers trade more than a billion shares a day at lightning speed. These trades have obliterated the age old strategy of "buy and hold." High-frequency trading is about buying and then quickly selling in a matter of minutes, seconds, or even mili-seconds.

By some estimates, "high frequency trading" is responsible for close to 70% of all volume in US markets. Computers can track hot stocks and immediately buy up all available shares. Since volume moves markets, this is quite advantageous. Almost instantly, these shares are then sold at higher prices. Millions of shares can be dumped in just milli-seconds.

High frequency trading has tripled market volume, giving a false sense of the size and activity of markets.

In August, the investment firm Knight Capital Group lost $440 million and was brought to the brink of bankruptcy due to erroneous trades caused by a software malfunction. Knight's trading algorithms went haywire, creating twice the normal volume the New York Stock Exchange. It was just the latest example of high-frequency trading gone awry.

In May, a technical error at Nasdaq (caused by high-speed trading) delayed the start of trading for Facebook’s initial public offering, limiting the ability of some investors to identify whether they had successfully purchased or sold their shares. Moreover, the offering price had also increased to $38 from an initial target of $28 - $31. Additionally, the number of shares had increased by 25 percent just days before the offering, diluting overall share value.

Ultimately, Facebook saw its stock collapse 32 percent in just 12 trading days.

Though top investors got word that research analysts at the banks underwriting the IPO had all cut their earnings estimates for Facebook just days before the stock went public, that news didn't reach the average investor until it was too late.

High frequency trading also helped drive the liquidity crisis and set in motion the ‘Flash Crash’ that rattled the markets worldwide in May 2010. In a matter of minutes, the Dow Jones Industrial Average plummeted a jaw-dropping 1,000 points.

But high-frequency trading isn't the only concern. There's also the matter of collateralized debt obligations (CDOs), credit default swaps (CDSs), interest rate swaps and derivatives. Credit default swaps were the things that got Wall St. behemoth JP Morgan Chase into so much trouble last spring.

In May, JPMorgan Chase suffered a multi-billion dollar trading loss that shook investor confidence. A single trader at the bank's chief investment office in London took huge positions in credit default swaps that resulted in massive losses. The threat of systemic risk in the banking sector was once again on full display, a reminder of its threat to the wider economy.

Each of these events undermined the essence of the markets; investor confidence. But cumulatively, they have had a most pernicious effect.

In June, the TABB Group, a financial research and advisory firm, released a report indicating that 31 percent of those polled said they had "weak" or "very weak" confidence in the stock market, compared to 15 percent after the Flash Crash.

In TABB's survey, a group of "market participants," including hedge funds, investment managers, exchanges and brokers, were asked to pick which recent market snafu did the most damage to the confidence of mom-and-pop investors in the stock market. Thirty-seven percent picked the Facebook IPO. Thirty-nine percent picked the Flash Crash.

Not surprisingly, retail investors have abandoned the stock market, moving their money into savings accounts, bond funds and annuities. Over the last few years, all of their suspicions have been confirmed that the stock market is a rigged game and they have largely refused to play anymore.

This is no small matter. Investors have been fleeing the stock market in droves due to a loss of confidence. The Investment Company Institute says that investors are pulling billions out of stock mutual funds on a weekly basis. In fact, investors have been consistently pulling money out of stock funds for five years running.

During the week ended Sept. 5, U.S. stock mutual funds bled another $2.9 billion, according to the Investment Company Institute, bringing the 2012 outflow total to more than $79 billion. By comparison, those funds lost in the neighborhood of $70 billion during the first eight months of 2011, and just $52 billion during the first eight months of 2010.

Vast numbers of Americans no longer understand the stock market and they certainly don't trust it. People would rather hide their money under the mattress than hand it over to Wall St.

According to the June Fed survey, just 15.1% of American families had any stock holdings in 2010, down from a peak of 21.3% in the 2001 survey. And just 8.7% of families had direct ownership of pooled investment funds (mostly mutual funds) in 2010.

Clearly, the ballooning stock market is not a reflection of the financial well-being of the vast majority of Americans. Most of them aren't even invested. The markets are simply Wall Street's betting games.

Joseph Saluzzi, a founder of the institutional brokerage firm Themis Trading, has long been an outspoken critic of high-frequency trading. In fact, Saluzzi thinks the practice is ruining the stock markets. He says it has created a loss of confidence that is scaring off mom-and-pop investors.

Here's what Saluzzi told the Huffington Post:

"The purpose of the stock market is supposed to be capital raising and capital formation. Investors are supposed to come, see what’s going on and say, "You know what, I like that company, I can invest and I’m going to hold the stock." Fifteen or 20 years ago, that’s what you had. Now ... the whole model for capital formation has gotten twisted into a short-term trading [system] where an average holding period for a high-frequency trader is seconds, not days or years... It turns it into a casino... You’ve lost the whole point of what a stock exchange is supposed to do. Which is identify undervalued assets, identify stocks that you think are going to grow... [The result is] a continued loss of trust and confidence in the stock markets. And that is the worst thing you can do. Because you don’t build trust and confidence overnight, but when you lose it, it goes quick."

The problem has been brought to the attention of Congress, yet nothing has been done to curb high-frequency trading and other risky practices that place undo risk on retail investors and the economy as a whole.

SEC Commission chair Mary Schapiro told a House Oversight subcommittee in June that investors have a "concern about the integrity of the marketplace," and U.S. markets are currently threatened with "an unwillingness [on the part of investors] to ever engage in the markets again."

People are unsure "whether they're getting accurate and honest information from [companies looking to list on exchanges]," Schapiro said, and unsure "whether the market structure itself is tilted against the individual investor and in favor the institutional investor." She added, "At the end of the day, investor confidence is the oxygen markets survive on, and if we lose it, it is extraordinarily hard to regain it."

Rather than curbing risky practices, government regulators are allowing them to spread. High frequency traders are now moving into currency and commodity markets.

This is an ominous development. Capitalism requires transparency and truly free markets to function properly. What we have, instead, are rigged markets.

Wall Street's intention has been to make the capital markets so opaque and so complex that no one — not even the regulators — can understand them. It's all been by design, and they've succeeded.

In the view of Wall St. bankers, they are the Masters of the Universe and no one should dare question them. They claim to know things the rest of us will never even understand. But in truth, their game is so convoluted that it's become incomprehensible even to them. They wrote the rules to this game and made it far too complex for anyone to follow or comprehend — even themselves.

Millions of individual investors have paid for that, and the price has been their savings — as well as their faith in the markets. That's a shameful development.