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May. 6 2010 - 4:53 pm | 424 views | 1 recommendation | 19 comments

Big Drop Thursday: Market plunge shows why we need a transaction tax

Today’s stunning market plunge and rebound, in which the Dow Jones Industrial Average swung 874 points in 13 minutes, is Exhibit A in why a transaction tax on stock trades is a good idea.

I’ve been a buy-and-hold investor since the late 1980’s, so while I don’t look at the daily fluctuations I think I would have noticed a day with such a dramatic swing, and I sure don’t remember one. (If I’m wrong, please correct me in the comments; I’d look through the charts myself but it would cause me to miss a deadline.)

The remarkable turn of events appears to be the result of computer-driven trading, in which trading firms employ software algorithms that automatically generate transactions. (For one thing, humans can’t trade at the speed required to move the market so far, so quickly.) These programs were blamed for much of the markets’ losses in late 2008 and early 2009, which saw a lot of days on which indices would plunge around 3pm after falling slightly, or even trying to rally, earlier on; the programs see a certain set of factors in place at a certain time of day and it sets off alarm bells, generating frenzied automatic selling no matter the stock and no matter the news.

There’s nothing wrong with these programs per se—in fact I’m sure they’ve helped market efficiency in some ways—but when a perfect storm happens they can wipe out trillions in shareholder value overnight, with no basis in fundamentals like EPS or EBITDA. When that happens, they’re acting on trends, not on the inherent value of companies which we’re supposed to be investing in. These algorithms are both a function and a cause of the transition of stock trading in recent decades from an emotion-driven casino where people and computers are betting on share price, instead of a rational market in which investors are buying a share of a company’s future earnings.

When I started watching the markets, a day in which a billion shares were traded was considered heavy volume. Today that’s typical for a Friday before a long weekend. A transaction tax would keep things from boiling over so frequently by putting a lid on much of the meaningless but stress-inducing volatility that gives traders and investors heart attacks.

A transaction tax—there are various proposals, but the one proposed in Congress would place a 0.25% levy on trades of $100,000 or more, and 2% on derivatives—would cause these algorithms to be recalculated on the side of caution. This wouldn’t affect Main Street investors, who generally don’t fool around with 100 grand at a pop and to whom the derivative markets aren’t open, but it’s estimated this plan would raise $150bn a year. It’s true that big institutional investors are trading with pension funds that affect regular folks’ pocketbooks and retirements, but the costs would be so spread out as to be barely noticeable, and in exchange we’d get a lot of market stability and send a lot of foolhardy players messing around with other people’s money to the sidelines.

Ask anyone who planned to tap their 401(k) or whose pension vested in late ‘08 or ‘09 if they’d give up a few dollars for every $100k of their nest egg in exchange for that.

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  1. collapse expand

    It involved the sudden disappearance of a mere $1.5 billion or so in wealth instead of the $10 trillion or so event that we saw today, but what happened to UAL’s stock in 2008 was pretty similar: http://www.theregister.co.uk/2008/09/11/ual_share_price_fiasco_analysis/

  2. collapse expand

    Your teachers, police, and firemen won’t like that……the government has invested trillions in wall street for public employee retirement

  3. collapse expand

    Mr. Levinson, Did you read the last line of the post?

    • collapse expand

      Taxes solve nothing……public pension funds for teachers, police, firemen are already exempt from capital gains taxees, because the government doesn’t pay taxes…..maybe they should start paying their fair share of taxes….

      Just as the money Obama is making off of GM ownership isn’t taxed because the government doesn’t pay taxes….

      In response to another comment. See in context »
      • collapse expand

        I’m still waiting for a cogent, factually correct, on-topic response from Mr. Levinson.

        First of all, “Obama” isn’t making any money off of GM ownership. To the extent that any money will be made, when all is said and done–itself in doubt–it will be the taxpayers who benefit. Including even you! The idea of the government paying taxesto itself is an amusing one; maybe you should pay your body rent for the use of its space?

        Secondly, whether public pension funds are exempt from capital gains has nothing to do with a transaction tax.

        In response to another comment. See in context »
  4. collapse expand

    What I really don’t understand is how someone who is a self proclaimed “buy and hold” investor can be so short sighted. So what if things go down ridiculous amounts in one day if your time horizon is really long term? There were some great deals today, and if you are truly a long term investor, you should love the opportunities dislocations like these create to pick up things you already wanted to buy at better prices. If you’re a true investor – you should love things like this. I personally will never be upset about anything that causes prices to behave irrationally – because the more irrational prices act, the bigger the opportunity for people who are truly investing.

    • collapse expand

      My concern in this post was not for my own assets, but the public interest. Anyway I doubt I or many individual investors would have been able to benefit from the sudden dip, for the reason Mr Carter points out below. I hear what you’re saying about profitting from irrational market behavior, and not to get into an argument about investment philosophies, but mine is to look for well-managed companies with a unique or near-unique product &/or access to a particular market and hold on to them for the long term (I’ve had some of my stocks for 20 years or more). Companies like these, experience has told me, are cheap at almost any price, so while daily dips can be serendipitous they aren’t typically worth waiting around for.

      In response to another comment. See in context »
  5. collapse expand

    This is one of the dumbest ideas I have ever heard regarding a transaction tax. If anything, the market action yesterday would call for less taxes and more incentive for market making. Bids were pulled because of market action, and fear of losing money.

    If anything, you should be calling for an end to payment for order flow, internalization of order flow, and the fragmentation of order flow in dark pools of liquidity.

    Only 23% of listed share volume was traded at the NYSE. The rest was done in back rooms.

  6. collapse expand

    I do believe that this is a very very bad idea like the previous comments, but I will try to take it as seriously as possible given how at first glance I thought the article was going to be a satire, based on the title.

    You write:

    “…with no basis in fundamentals like EPS or EBITDA. When that happens, they’re acting on trends, not on the inherent value of companies which we’re supposed to be investing in. These algorithms are both a function and a cause of the transition of stock trading in recent decades from an emotion-driven casino where people and computers are betting on share price, instead of a rational market in which investors are buying a share of a company’s future earnings.”

    On what basis do you determine that your methodology for evaluating the value of a stock is superior to the methodology used by everyone else? Even if your methodology is in fact superior (which you have no way of proving), what makes you think you should be imposing this methodology on everyone else if they prefer to use a different one?

    There is a very simple solution to circumstances like this that arise in life all the time. If you don’t like how people are behaving/interacting/acting in something, don’t take part in what they do. If you don’t like how people trade on the markets, don’t invest. There is no inherent right to investing in markets with a buy and hold strategy.

    • collapse expand

      I have no intention of imposing my methodology on anyone. But if people or computers or institutions want to trade in a way that increases the risk for investors who are not party to their transactions, I don’t think it’s unreasonable that they should pay a quarter of a percent for the privilege.

      In response to another comment. See in context »
      • collapse expand

        What do you call imposing a tax on someone’s behavior that you don’t like, other than “imposing your methodology on someone?” Your belief is the same no matter what the amount of the tax, so a quarter of a percent is not something you can hide behind.

        Is there an inherent right to investing in the stock markets that you are trying to enforce?

        Also, how did you decide a quarter of a percent is proper? Could you please elaborate on the calculations you did to arrive at this? Why not a tenth of a percent? Why not 2%? Should we just take your word for it that a quarter of a percent is correct? Should we all have a discussion about “what percent transaction tax is needed,” even though not a single person or group of people has the knowledge necessary to even begin to know what percent tax would do anything constructive (except prevent people from engaging in transactions that they want to engage in but will no longer be able to as much since the all-knowing Paul Tullis decided they shouldn’t)?

        Right now your suggestion looks like nothing more than a random number thrown at a non-problem that you can’t see won’t even be “solved” by your suggestion in the first place.

        “Got cancer? Robitussin!”
        “Got too many transactions? Tax ‘em!”

        In response to another comment. See in context »
        • collapse expand

          Slow down, amigo! You’re misrepresenting me, changing the discussion, and making incorrect comparisons.

          1) In your original comment, the phrase “imposing this methodology” seemed to be referring to my investment philosophy, coming as it did after the phrase, “your methodology for evaluating the value of a stock…” Now you’re saying it’s about the tax. Which is the conversation you’d like to have? Either way, I don’t want to “impose my methodology.” I hope the decision will be enacted through the democratic process, as was clear by the citation of the proposal in Congress. Huge difference.

          2) I didn’t decide 0.25% is proper; I merely pointed to it as an idea that’s been proposed, then used it as an example. I think we should have a discussion about what percentage transaction tax is needed, actually, and I don’t know why you think nobody could figure out what its effect might be. This is what economists do all day: They build models. And I never suggested that this happen because I said so; the obvious implication is that it be debated in Congress like other laws and taxes.

          3) The Robitussin analogy is ineffectual. You say that the tax would “prevent people from engaging in transactions that they want to engage in” (actually, it would impose a cost on them for engaging in the transaction, not prevent them from doing so). So you admit that it would be effective at reducing the number of transactions, which is the intent. But you compare this to giving cough medicine for cancer, which would not produce the desired effect. Therefore, not analogous.

          In response to another comment. See in context »
          • collapse expand

            1) This is funny because I actually changed how I meant the statement (as you point out), because I thought you misunderstood how I meant it originally, which I now know is not the case. The truth is I would argue both of the ways I said it, so it doesn’t matter which interpretation you pick. And also what is it about the democratic process that makes the outcome legitimate? Let’s assume you thought the Iraq War was a mistake. The legislative process brought a leader into power who began the Iraq War. Was it legitimate because he was democratically elected?

            2) Economists build models and end up blind-sided by financial crises. How useful. For a model to be accurate, it requires a level of sophistication that no computer even has. This is why every policy, like taxes, has unintended consequences. Also, once again, what makes the outcome of a debate in Congress legitimate?

            3) The analogy was mean’t to inject humor here. But in terms of what you said, imposing a cost on them for engaging in the transaction is causing the marginal transaction from taking place. That is preventing a transaction from happening. That is also basic economics. Under certain circumstances (the ceteris paribus assumption economists love to make), the tax would reduce the specific type of transaction you are taxing. The problem is what types of more different transactions would now take place in the marketplace that didn’t take place before. So in the end, you don’t even achieve what you tried to.

            I feel like we are getting off topic so let me try to fine-tune what I am hoping you could answer for me. There are individuals in the stock market who trade with each other. Yesterday, they traded in a way that you did not like. If those individuals do not force anyone else in society to get involved in the stock market and potentially suffer losses, on what grounds do you propose a tax on transactions? Just because you don’t like how some people are choosing to voluntarily transact with each other? If I get enough people to say they don’t like reading your articles and have Congress debate a law that charges you money every time you want to write an article (the debate is over how much to charge you), is that a good proposal or would you more than likely tell me “you don’t have to read what I write, but why do you need to charge me for writing my stuff if maybe there are some people that will want to read it?” The issue here is that you are trying to marginally stop people who are doing something you or anyone else does not have to take part in.

            In response to another comment. See in context »
  7. collapse expand

    Oh, forgot one thing: I’m not some crazy ignorant pinko on this. Numerous Nobel-winning economists favor a transaction tax too. Not that that makes them right–I’m sure other Nobel prizewinners oppose it–I’m just saying it’s a fairly mainstream point of view.

  8. collapse expand

    I’m glad we’ve been able to keep this civil! I do not mean that sarcastically; I really appreciate your thoughtful responses.
    You’re right that just because something was enacted by Congress doesn’t make it the correct policy; my quibble was with your seeming to say that I wanted this to be “imposed,” which to me sounded like you thought I wanted to enact it dictatorially (“the all-knowing Paul Tullis…”).
    I don’t think models are perfect, but I do think we could “begin to know” the consequences of a transaction tax. Much bigger changes have been made to the economy, and the sky didn’t fall.
    I hear what you’re saying about the law of unintended consequences. But other countries–including the UK, which is where Republican Senators say the whole derivatives market will flee to if we dare regulate it–have these taxes already and seem to have managed. Also Japan, Sweden, Taiwan, Korea and Hong Kong. I don’t see sophisticated investors deciding not to trade on those exchanges because they have to pay extra fractions of pennies on the dollar.
    To answer your on-topic question: The people who might be negatively effected by radical swings induced by algo trading are already in the market. Most of them are not active participants but have their retirements invested through mutual funds and pensions and the like. Should they be excluded from the best long-term returns so some very sophisticated market participants can reap every possible cent of profit? My chief interest isn’t in protecting free markets, but a stable democratic society in which everybody has a chance to access its fruits. I think giving the markets a chill pill could help achieve this. A transaction tax probably isn’t the only way, either; algo trading could probably be limited in other ways–of course, the Supreme Court would probably overturn it based on free speech ;-) .

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    I've been writing and editing for national magazines for 11 years, the last few specializing in environmental journalism, with additional experience producing daily news for, and appearing as a commentator on, public radio, and editing and managing a website.

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