How the Stock Market Has Changed Over the Last 30 Years

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In a previous blog article, I reviewed the past 30 years and how things have changed in so many areas of my business during my career as a planner.

Today I want to expand on the changes in how the stock market functions and the risks that I hope you can understand and use to both protect your wealth and profit from this knowledge.

A Dynamic Change

Over the past few decades there has been an explosion of strategies and money flows from institutional investors (pension plans, hedge funds, etc.) relative to the market participation of individual investors. This dynamic change has made it more difficult for individual investors to be successful due to these imbalances in market participation.

I am hoping the information here will help you to avoid getting caught up in a market downturn.

The market today is far more volatile than it was 30 years ago, and I see much confusion as to how to cope with it. While the Wall Street “wisdom” hasn’t evolved as to how you need to stay the course, stay invested no matter what and always buy, buy, buy, regardless of the market being up or down (remember “dollar cost averaging”?).

Over the past 30 years, I have noticed that there are lots of ways to suggest you should buy stocks. Things like “the market always comes back, so don’t try to time the market” or “it’s time in the market, not timing the market”, and even automatic enrollment in some 401k’s that put your payroll deductions into a default mutual fund (usually a “target date fund”) that has some stocks in the portfolio.

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What’s Stayed the Same?

The one thing that is the same today as it was 30 years ago is the fact that analysts still don’t tell you when it is time to sell. The closest thing to that is when they change a ‘buy’ recommendation to a ‘hold’ recommendation. Outside of that, you are expected to buy and never sell.

After all, given the current model of charging you a fee that is a percentage of the assets you have invested, they won’t get paid if you sell. Back then, brokers got paid based on transactions (buy and sell), not based on “assets under management” (AUM). One of the results of this change is that brokers no longer pay as close attention to your holdings as a separate manager oversees the investing and the broker is there to answer questions and develop the relationship. There are pros and cons to each model, the point is to be aware of the change in incentives for those you are working with.

The Two Biggest Changes

So, let’s talk about the 2 biggest changes in the market. One is computer-based trading and the other is indexing. I feel that these two factors have had more to do with the way market is today than any of the other developments we have seen. These have changed how the market behaves and understanding that these differences will likely influence the wealth building outcomes you will realize.

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Computer Based Trading

This was something that wasn’t that big back when I started. However, now that computers are so much cheaper and access to data is more readily available, this type of trading has been taking over and accounts for the vast majority of the daily volume in the market.

Back in the 90’s, early adopters were doing day trading using personal computers and placing orders via computer and dial up modems (which could be so slow that sometimes it was faster to call in your order). Institutional traders were using faster computers, but mainly for technical data analysis and to track positions and adjust strategies for selling or hedging. When you placed an order, it went to a “market maker” who matched buyers and sellers. 24 hour trading and off market trades were not a “thing” yet. Today, you can buy or sell New York Stock Exchange or NASDAQ shares 24 hours a day!

This development let the Exchange to upgrade their technology to allow direct contact between the computers that “clear” the trade and the computers from High Frequency Traders who are placing trades and executing huge transactions in a fraction of a second! This allowed the stock exchanges to protect their business and has led to a huge increase in volume. There was a very interesting piece from 60 minutes on the effects these folks are having on how the market functions and what it costs the individual and some institutional investors who have to compete with them.

Michael Lewis wrote a book called “The Flash Boys” to help people understand how this changes how the market behaves. There are many who believe this contributes to the increase in volatility we are all experiencing over the last few years.

The other thing that technology has contributed to is technical trading. Lately you may have noticed that as stocks, or more importantly indexes, move, there seems to be levels where both up and down movements accelerate.

The easiest to spot are trading activities near round numbers. When indexes or stocks hit those levels, pre set buy or sell orders get triggered. These days a lot of traders seem to be picking identical trigger points, so when reached, the moves are more intense.

What This Means to You

You can currently see the effects of this type of institutional trading in our oil market. Oil has dropped more than 20% in the last 12 trading sessions as I write this.  Simultaneous to that natural gas is up 38% during the same period. Apparently, there was a huge amount of speculation that natural gas prices would go down and oil prices would rise at the same time. This is a fairly common type of trade in the futures markets, to go long one commodity and short another when their relationship is usually inverse. When things start to go wrong in this type of trade, there will be margin calls that require the owner of the contracts to post more money to protect their position. After a while, traders get tired of putting up more and more margin deposits and they sell (it is called “covering” their positions), triggering more sell orders which in turn accentuates the price movement in that direction, either up or down.

Because of the speed at which these movements can happen, it makes it harder for individual investors to react and protect their portfolio. For example, the movement in oil and gas is now spilling over into the stock markets, which is a connection that many investors won’t make.

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Index Funds May be Riskier Than They Appear

The other big change is in the use of index funds, particularly those on the popular indexes like the S&P 500 (SPX), NASDAQ (QQQ), and Dow Jones Industrial Average (DJIA).

Vanguard has become the world’s biggest mutual fund sponsor because of this revolution. Just buy a portfolio of index funds and forget about them. Rebalance occasionally and voila, you have nothing to worry about. After all, most “managed funds” have not beaten the indexes for long periods of time.

In light of the above, which many investors cite almost as religion, an ever-growing amount of market participation is based on people buying these types of index funds. Today, according to the LA Times, the total amount invested in passive index funds (open ended mutual funds and ETF’s) is 42%!!

What this means is that the stocks that are part of the index are being bought and sold, without regard to their value. If I send money to an index fund, the manager has no choice but to purchase all of the stocks in the index. This has bid up the price of many stocks way above what their fundamental value represents. When prices are rising, and more and more people buy an index fund, those values climb even higher, which increases the risk in terms of how far down stocks can go when they do go down.

History and logic tell us that when a lot of people buy the same asset type because “everyone is making money”, the risk of losing goes up dramatically. After all, if we could all do the same thing, and have it work out, we would all be wealthy. Obviously, this isn’t the case.

There is No Risk Until There is

In the 90’s you could buy anything labeled .com and made money, until the bubble burst. In the early 2000’s, you could have bought any house in any neighborhood and make money, until you couldn’t. I can’t be sure this will happen soon in stocks, but there are many examples of risk being built into a specific investment (ever hear of Tulipomania?), without participants seeing what is happening until it is too late.

Over the last 30 years, stock market participation and trading volume have risen dramatically. This has led many stocks or other assets to become very pricy relative to their historical intrinsic value.

History suggests when this happens that volatility and risk increase along with participation. Keep this in mind, especially if you participate in the stock markets today.

If you would like more information on this topic, or information on strategies and options to reduce the potential for loss, contact us and we can discuss.