There is a decent argument that stock markets have condensed an entire three-year cycle into three months. While there are other factors at play, robotic trading is accelerating both the speed and magnitude of stock market movements. I'm not expecting robots to go away, and how investors look at the market will need to adapt.
A typical cycle
Assume you were programming a trading program to switch between assets and strategies throughout a cycle. Into this trading program, you might want to program something similar to this:
- Stock market blowoff followed by a bust.
- Corporate debt prices fall, and yields increase.
- USD safe haven and bond bid.
- Flight to quality in stocks.
- Government/central bank intervention.
- Bounce off the lows for stocks.
- Momentum trades kick in, driving the stock market higher.
- Bonds start to sell, USD safe haven unwinds.
- Rotation to value and cyclical stocks as the recovery unfolds.
- Bond yields rise further, usually due to inflation.
i.e. your program would want to be looking for each event to occur, and then move into the next asset in the list.
It is a robotic arms race
Now, assume there are others out there doing the same thing as you, programming their robots with similar logic. Sometimes the logic would be explicit from macroeconomic underpinnings. Other times the rationale is implicit - someone's machine learning code has worked out the next step, but the programmer has no idea why. Nor, usually, does the programmer care.
In this case, you want to be quite quick about your transitions. i.e. if you can be first onto the next phase of the cycle, you will make more money than if you wait.
The electric sheep
Now, not every quantitative trader is programming the above. Actually, very few are.
Most quantitative traders tend to momentum-based, an inherently simple strategy:
- You see assets going up then you buy them.
- Assets stop going up then you sell them.
It is a surprisingly effective strategy over time. It usually makes a little bit of money most of the time, and then loses a lot of money in very short order. Over the cycle, it usually wins.
There are a lot of quantitative traders out there following momentum strategies under a range of names and guises. A lot of hedge funds have this strategy. Commodity Trading Advisors (CTAs) do as well. Many quant funds or smart beta ETFs also follow this strategy.
Numerous retail traders also follow a similar strategy. Technical analysis is (usually) just a flavour of momentum trading.
How many electric sheep are there?
A lot. And it appears to be a growing number. We are going to look in more detail in today's podcast at the numbers behind this.
Putting together the robots and the electric sheep
The cycle check-list above is pretty much what we saw over the last three to four months, just in ultra fast forward compared to how it would usually play out. No doubt in some way spurred on by the increase in momentum traders and retail traders.
The fall made sense. The economic consequences are significant, with the highest unemployment rates since the great depression in many countries.
The initial stages of the rise made some sense. Governments and central banks removed the worst-case scenarios by the speed of their actions.
Which gets us to stage 7: Bounce off the lows for stocks. How much was the bounce has been magnified by retail traders and momentum players? At least some, potentially the majority.
Stage 8 and 9 have been even sketchier. A rotation to cyclical and value stocks usually happens when the economic recovery is underway. The rotation seems premature at best, delusional at worst.
Is it possible that the machines are simply racing to get to the next stage of the cycle before everyone else, and then the momentum traders are pushing the trades even further? And neither is paying attention to the real economy.
i.e. the robots are dreaming, and the sheep are following.
Market movements following the US Fed last week lend more credence to the theory. A touch of reality from the Fed was enough to send bond yields back down and cyclicals tumbling. But, if the above theory is right, last weeks moves were just some restless murmurings of the slumbering robots. The real issue will come if the robots awake in fright.
Which leaves us essentially with two options:
- The market is presciently pricing in a future recovery despite the earnings numbers get worse and the V-shaped recovery failing to materialise.
- The robots and momentum traders have extended a normal bear market bounce into some of the highest valuations ever despite economic conditions.
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What frightens a robot? A volume of sell orders it is not comfortable with?
Great piece thank you. It would appear that fundamentals are being ignored totally in favour of technicals with the flock following. Are the purchases being made on margin or is the economy awash with cash through debt monetisation? If the latter we may have this dislocation for some time yet.
Andrew - I probably took that analogy too far! What I meant is that the momentum players will push the market past equilibrium in both directions. Recently they have been pushing the market up, but I think the effect will also work in the opposite direction.
Andre - we had a look at this in detail in a podcast today: https://www.youtube.com/watch?v=pIEGsbanBh8&feature=emb_logo Will write something up for livewire soon.
I've been firmly in the bear camp since end Feb... watched in great excitement prices falling and benefited greatly through bboz... however, couldnt take much benefit of rising mkts coz of my bearish outlook, even a small blip was sufficient to sell my holdings... I guess, what matters is not if you are right or wrong in this game... what matters is did you earn money? I rather be rich than right..
Some people have plenty of good reasons why the market is going to crash since end of march
Thanks Andrew. Very interesting. My robot is starting to look confused by the market but as Hunter S Thomson said; when the going gets weird the weird turn pro.
"It's possible now that the marginal buyer of markets is a bot or an algorithm that doesn't actually hear rumours, only published data. That old function - "I'll buy the rumour and sell the fact" or vice versa is not actually working anymore. Markets are not discounting the negative picture of the next six months. So, they've either lost a lot of the discounting capability and are just looking at the benign conditions that are currently on paper, or markets are looking all the way through to the end of this, even though we really don't even know how far in the future that is." - Kate Howitt from First Links article
David Rowland "when the going gets weird the weird turn pro" reminds of David Portnoy at the moment: Rule 1. The market always rises. Rule 2. When it doesn't, refer to Rule 1. Only now could this be true.
Thank you Damien, always enjoy your article