It's a Trader's World -- You're Just Living in It

It's a Trader's World -- You're Just Living in It

There's no question that 2013 has been a great year for stocks with the broad market up over 25%, but it was by no means a given that stocks would boom this year. Going into 2013, investors were dealing with the government standoff known as the "fiscal cliff," an unemployment rate near 8%, recession in the eurozone, and the re-election of Barack Obama, which had disappointed many on Wall Street.

Few prognosticators predicted that these factors would lead to such a crushing win for stocks, but both the S&P 500 and the Dow Jones Industrial Average have set numerous records since, recently eclipsing milestones of 1,800 and 16,000, respectively. The records have come as the unemployment rate has fallen about a percentage point to 7.3% -- approaching the Federal Reserve's goal of 6.5% -- the European economy has shown signs of life, and the market has learned to ignore the budgetary shenanigans in Washington.

Perhaps most importantly, stocks have responded to the Federal Reserve's repeated decision to continue its $85 billion monthly bond-buying program, which has kept interest rates and bond yields artificially low, propping up equities as the better alternative to fixed income.

For buy-and-hold investors, the Fed's actions are essentially meaningless, as they are unlikely to have a significant long-term effect on corporate profits, but buy-and-hold investors do not control the market; traders do. And their response to the Fed's decisions has been the biggest factor in determining the stock market's movements this year.

This was on display in September when the Dow jumped more than 100 points in an instant, and more than 200 in an hour, following the Fed's surprise decision not to begin its stimulus tapering. My colleague Morgan Housel observed that stock market returns would have been essentially flat between 1994 and 2011 excluding the three-day periods around the Fed's Open Market Committee announcements, and there seems to be a simple explanation for that: Short-term traders, who respond to such decisions, are the ones directing the market.

Those of us who consider ourselves "investors" often bemoan the rise of the day trader looking to make a quick buck. Investors tend to believe they are the true stewards of the market, allocating their capital to companies that have the long-term positioning to generate strong returns, and they see traders as interlopers trying to game the system, using questionable tactics like technical analysis to turn a profit. Warren Buffett, the paragon of long-term investors, has said he buys stocks under the assumption that the market could close for the next five years -- with an attitude like that, the market seems almost unnecessary.

But with the proliferation of technological tools for data analysis and high-frequency trading, short-term trading has come to dominate the exchanges. The average holding period for stocks was more than 10 years in the 1930s, but it has fallen to just six months or less, according to some estimates, as investors have grown more impatient and participants have tended to see the stock market as a casino for making bets on securities rather than a vehicle for long-term wealth-accumulation.

But in a year like this, with 26% stock returns on earnings growth of just 3%, perhaps long-term investors should be thanking traders for pumping up the market.

Either way, there are a few lessons that buy-and-hold investors may want to keep in mind in a market fraught with high-frequency trading.

It's all about liquidity, baby
Perhaps the biggest way traders help the market is by making it liquid. After all, for every buyer there needs to be a seller. Plus, if everyone held their stocks for 20 or 30 years, bid/ask spreads would be much wider than they are, and transaction costs would be much more expensive, like you usually see for penny stocks, options, or other low-volume securities. Highly liquid markets are also less volatile, as changes in supply and demand tend to have a small effect on price, and the prices of securities generally move incrementally, rather in large jumps.

Liquidity is one of the best reasons to invest in stocks, as they can be disposed of in a matter of minutes with the click of a mouse, as opposed to other assets such as real estate, which often require months on the market to sell and incur high transaction costs through agents and other fees.

Not all turnover is created equal
Some stocks are especially popular with day traders. These tend to move in large swings and are often beaten-down companies that some see as a value play, or heavily shorted companies that many believe are overvalued. Long-term investors are probably better off avoiding companies such as these. An easy way to check is to look at the percentage of shares outstanding that are traded each day, which you can do by dividing the average volume by shares outstanding.

J.C. Penney , for example, has seen an average of 13% of its shares traded each day over the last three months. That means the average holding period for each share is less than eight trading days. Additionally, 51% of the retailer's shares are sold short, and over the last three months shares have moved an average of 3.3% each day as opposed to just 0.54% for the S&P 500. During that time, the company's price has dropped from $14 to just north of $6, before climbing back above $9. Given those statistics, it's no surprise that the stock has been pillaged by day traders. Someone's making money off those movements, but for long-term investors that volatility should be a red flag.

Not all stocks turn over once every eight days though. Stable blue-chip companies tend to trade at much lower volumes, and are often free from short sellers and day traders. Dividend stocks also generally see less volatility then their non-dividend-paying counterparts. Take a stalwart like Coca-Cola for instance. Coke is one of the best-returning stocks in the history of the market, and until recently it had the world's most valuable brand name. Not surprisingly, Coke shares change hands barely more than once a year on average. This is the type of stock you keep with you for the long haul, a solid dividend payer and a cash flow machine that you can count on for retirement. It's a steady and predictable company: It won't go out of business anytime soon, nor will its sales double next year.

Ignore them doing this
While traders may manipulate the market in plenty of ways, over the long term their day-to-day machinations shouldn't affect your portfolio. After all, stock prices are based on the underlying value of real companies that generate actual profits. As those companies' profits grow, stock prices should rise with them. Fundamentally, corporate earnings are the basis of share prices -- not the Federal Reserve or the short-term bets of traders looking to make some fast cash.

Valuations fluctuate, but one of the most powerful rules in finance -- reversion to the mean -- will eventually prevail. The S&P 500 has historically traded at an average P/E of 15, but after this year's surge its P/E is near 19. We may not be in a bubble, but this year's extraordinary gains are a reminder that buy-and-hold investing is not always a smooth ride. Be prepared for the fallout, and remember it's all part of normal market dynamics. Investing in sound companies with growing profits and holding them for a long period of time has almost always paid off.

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Fool contributor Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola. The Motley Fool owns shares of Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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