Computer trading adds up for Dow

Ground Floor: My mailbox was full of alerts telling me that the Dow finally breached the 11,000 mark for the first time since June 2001 this week. (These are the kind of moments that make chartists and equity traders bristle with excitement and I raised an eyebrow in pleased acknowledgement myself!)

But most market professionals are trying to decide whether investors will see the breach as a sign that equities are an asset class to get involved in again or whether it's merely a false dawn for the Dow. The reality is that for most of 2005, returns on components of the Dow were relatively modest if not heart attack inducingly awful.

Going through a big resistance point like 11,000 is a key moment for traders and investors. There seems to be a view among traders that the encouraging start to 2006 will make the general public look at equities in a more positive way. Of course, the real time to look at equities positively was after the carnage of 2001, but that's not such an easy thing to do!

However, according to Richard Moroney, editor, Dow Theory Forecasts, stocks are in a bullish uptrend if the industrial and transportation averages break out to fresh highs simultaneously.

This is what's just happened and analysts are now coming out all bullish. The recent breakthrough was helped when the beleaguered General Motors was upgraded by Goldman Sachs at the start of the week. The bankers were dismissive about the possibility of an imminent bankruptcy filing and its support of the company saw its price rise by nearly 8 per cent.

The Dow was probably one of the most miserable indices for investors in 2005 precisely because it contained big companies like General Motors, which declined 44 per cent over 2005, compounding a 25 per cent drop the previous year, while Pfizer, Coca-Cola and IBM have been taken over in investor consciousness by great performances from Google and Apple.

But the truth is that despite the cheapness of some Dow components and the opportunities offered by some of the other indices, investment money has been flowing out of the US and chasing stocks in emerging markets. These markets were seen to have much greater potential and that's what had such a bad effect on the Dow, ultimately causing it to post its first down year since 2002.

Yet the commentators still look at the headline index when they talk about the health of US equities. This is why the Dow has changed its indices' components, to make it reflect the modern economy better.

While most of the attention this week is focused on the Dow's performance, the fact is that - despite the bad time for the blue-chips - the big Wall Street firms have done very well out of equity trading over the past 12 months. Citibank reported that third-quarter revenue on its equity desk increased by a whopping 78 per cent while Merrill Lynch, the biggest firm by market value, is expected to announce a 40 per cent increase in revenue later this month. Lehman's, Morgan Stanley and Bear Stearns have all seen good results from equity-based products.

The hot and heavy demand for equities and their derivatives and the resultant income for the Wall Street firms has been coming from hedge funds, who are now switching their interest from fixed-income products into equities and who are trading like dervishes to keep ahead of each other and the markets.

It's been working. Despite a poor start, the average hedge fund returned 9.18 per cent in 2005. At the same time, the S&P index returned just 3 per cent and, of course, the Dow dropped slightly. So all of that switching in and out of stocks and their derivatives paid off - good news for hedge fund managers who didn't do so well in 2004 when a number of different funds closed up shop and their eager traders sloped back to the slightly more sedate world of mutuals. New regulation, due this year, will probably enhance the reputation of hedge funds, taking them out of the lightly regulated fly-by-night territory and putting them on the mainstream investment radar.

Although the private client likes to imagine high-profile individual funds managers mulling over stock picks, many investment decisions are made by computer programs using mathematical models to determine the right time to buy and sell. As each institution develops more computerised models, they have to try harder to generate returns and, in turn, end up trading more.

It's this constant trading which is generating such good money for the Wall Streeters and making their equity desks look so profitable. Hedge funds, as you are aware, are supposed to be able to generate returns, no matter what the direction of the market. Their constant trading is generating those returns for the big firms too!

Computerised trading has come a long way over the past 10 years, with the programs becoming more sophisticated. I wonder what will happen when the "perfect" program finally arrives. I can't help thinking of an episode of Star Trek in which warring races were waiting for the optimum time to strike their opponent to ensure maximum damage.

Since each opponent was constantly upgrading its army and equipment, the optimum time never came, but they sat around for a long time waiting. Heaven knows what that would do to the Dow.