The market confusion referenced in our last commentary has somewhat resolved itself as the final quarter of 2018 closed. The 10-year Bull market has been abruptly interrupted as the Bear emerged from the woods with a vengeance. Having been held in check by an accommodative Fed for most of that period, it now appears the Fed has decided to change the last decade’s rules of the game, and return to a “normal” universe, whatever that means.
The beginning of this chimney sweep started when the FAANG stocks started to hit a reality moment and come back to earth for any number of reasons, not the least of which was over-valuation. They had long become a significant driver of S&P 500 gains, providing the momentum for an upwardly driving stock market. However, momentum can cut both ways, especially as algorithmic (read as computer-driven) trading, dominated by momentum strategies, is in control, and they don’t care about direction.
Nor do they care about the value of the underlying securities represented by their tickers. The computer is a soulless machine and doesn’t care if your company is good or evil, only its weight in an index or exchange-traded fund.
This facilitates an environment where volatility has become exaggerated as algorithms have come to dominate trading volumes. By some estimates, computers now drive as much as 80-90% of total trades. When the programs start to move in one direction, even for a few minutes, 500 point moves become common.
ALGORITHMIC TRADING HAS TAKEN OVER THE WORLD
In the epic 1984 sci-fi classic “The Terminator” an artificially intelligent (AI) defense computer program takes control of the missiles, and decides to destroy humanity. Today, market trades are significantly directed by computer algorithms, whether passive re-balancing, quantitative hedge funds, or the flash traders made infamous in the Michael Lewis book “Flash Boys”. There are already too many examples of these programs going off plan and up ending the market.
The exponential growth of computer-driven trading, low and “no cost” index funds, and exchange-traded funds, has manifested itself in pronounced trading activity. First sold as a boon to the small investor and enabling them to “invest like a pro” at lower and lower expense, both the investment vehicles and trading programs have morphed into their very own supercomputer-driven trading-industrial complex.
These firms exert outsized control on Wall Street given that much exchange revenue is now derived from these trading machines. Remember, they don’t care about the direction of the market, only the opportunity to extract a fraction of a cent per trade, on billions of trades, every day. They pat themselves on the back about how much liquidity they create, but it only serves the algorithmic traders, certainly not long-term investors, retail traders, or any individual who thinks he can beat hundreds of supercomputers at their game. The short-term trader becomes road kill, much like humanity in the aforementioned movie.
AND THEN CAME THE FED, TO “FED” THE BEAR
On December 19th, the US Federal Reserve Bank raised short-term rates for a fourth time in 2018. Given recent heightened levels of market volatility, it was believed they might hold the line for a few months, allowing markets a chance to settle down. So much for hopeful thinking.
The Federal Reserve Chairman stated at his press conference the Fed was not concerned about market volatility, only unemployment and price stability. This may have been the Fed’s legal mandate before the 2001 crash, but it has morphed into economic salve for the damage of two great market downturns.
Unemployment remains at all-time lows, inflation is quiescent, and long-term interest rates recently fell almost on top of short-term rates. In our view, this last move by the Fed made no sense in view of their historic mandate. Trying to correct for the extraordinary path of the last 18 years in a one year time frame is, to put it mildly, dangerous. The market agreed.
The Algorithms got the message, and at a time when human market players were visiting families on holiday, Christmas shopping, or on extended vacations, the Algorithms trashed the market on Christmas Eve. Merry Christmas.
HOW TO WIN
Benjamin Graham, one of Warren Buffet’s early mentors, and author of a number of renowned investment classics, famously spoke of trading and investing,
“In the short run, the market is a voting machine but in the long run, it is a weighing machine,” and,
“The intelligent investor is a realist who sells to optimists and buys from pessimists.”
Winning at investing means staying focused on your long term strategies and goals. Volatility is a necessary part of capital markets, and markets may get stretched too far to the upside as well as the downside. This is what we are experiencing now, even as the economic environment remains generally healthy. The opportunity is to remain an investor – buy low, sell higher in the future, and not to play someone else’s game.
Smart play? – Remain disciplined and stick to your long game.