How the Quants Perpetuate Market Distortion 18 comments
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A relevant long-term proxy for the increasing presence and relevance of quant trading in equity markets is the widening volatility (width) in the advances-to-declines band (observed via ADLN in Bloomberg, or TICK for intraday breadth movements).
The latest widening of volatility bands for advance-decline occurred around start of quant craze. Long-short quants received large capital allocations from pension funds and endowments in 2004 and flood gates really opened up in 2005. By the end of 2005, relentless momentum chasing become the rule of the day and quants have taken over a large swath of trading landscape. There are many reasons for the explosion of this so called "portable alpha" concept that included market neutral quant funds, funds managing CDOs and other credit instruments. Cheap credit was, not surprisingly, the chief culprit. Quants feasted on cheap leverage and delivered steady returns, superior to treasuries with similar super low risk to AAA rated CDOs. Investors didn't know about the risks until August of 2007, but even subsequent, have learned nothing from this experience.
What this chart shows is that vast systematic volumes of quant strategies in various time frames have become a destabilizing factor due to a convergence of strategies. In the end, the only way to win is to buy stocks that go up and sell stocks that go down and all strategies, no matter how many PhDs portfolio managers are involved, and so quants had to be in the same stocks, at the same time, swinging the market widely under their own weight. The bigger funds took the lead and the goal of smaller ones become to figure out what bigger guys will do the next day.
The rest of the story of how the phenomenological price driven model took over the market action is history. Many books try to monetize by providing extensive explanations, some throwing around "philosophical" terms such as reflexology, other using assorted black birds to describe the simple phenomenon of the equilibrium point shifting after too many manic speculators jump from one side of the increasingly larger boat to the other. With the cheap credit spigot closed, not only are the same manic speculators now jumping off the boat completely, but the boat itself is becoming rapidly smaller. What/when the new equilibrium will be reached, is anyone's guess.
Quant funds followed the credit cycle and technology progress, and as computers became cheaper and credit/money got mispriced, quant funds developed into a dominant force. August 2007 was billed as a once in a 1000 years event that will never repeat. It did, though not as devastating, but painful nevertheless... And will repeat again quite soon.
Just what does the science of astronomy or physics have to do with uncertain, emotional markets? Why should the past repeat and why should large, highly leveraged positional bets be allowed on that premise? How is that any different from AAA CDOs constructed from sub-prime RMBS? Rating agencies made flawed assumptions, and now the prop risk managers allocating the bulk of the trading capital for the de jour hot quant manager, are making comparable mistakes, disguised as "assumptions" yet again.
CDOs managers bought RMBS aggressively, prolonging and exacerbating the housing bubble. Risk managers allocating capital to quants are prolonging and exacerbating the long-term bear markets in equities, creating an atmosphere of distrust and making markets unreliable tools of price discovery and playgrounds for rampant, Atlantic City-like speculation.
In the words of both a NYSE chairman, and a famous credit index trader, "this will all end in tears."
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This article has 18 comments:
You're all a bunch of second class citizens compared to gamblers. Gamblers have rules and the rules make sense.
HAHAHAHA.
Its like 9 guys sitting around a poker table each with $10000 in chips trying to figure out a way to make sure no one walks away from the table with anything.
They play with house money - if they lose the investors hold the bag. The only way money is made on Wall Strett is by versions of Ponzi schemes - find a bigger fool.
If this type of trading continues unabated, there will be no reason for anyone to invest in stocks at all. Owning stock was once thought of as actually participating in ownership of a business, whose underlying value was reflected in the stock. Now it's just a ticket to a circus where computerized beasts chase each other around in circles.
I find it kind of a logical evolution: once information is known, its priced in. old fashioned stuff like picking stocks is a known game : the average investor can do that with all the information available these days. so the game is forced to move deeper, to evade this pesky average-man investor (ie "portable alpha" – getting the biggest slice).
on the one hand that's trading faster than humans can react (the other hands being exotic options, exotic credit markets, dark pools that don't move the official public market. the main market is almost a hood ornament compared to what the exotic credit markets are doing.)
I envision the market eventually turning into very fast trading, say 1000x the current speed. people will forget about waves (charts) and move to some kind of scattering theory analysis. seriously. human trading is already on its way out.
already watch SKF using book trader and the bid/ask/trades are just spastic. its like catching paint with a tennis racket.
... of ill-omen.
State Street says that the "flows into U.S. equities [from institutional investors] were close to the highest they have been in 12 years." This would seem to contradict Tyler and Duncan Niederauer's comments.
> jack
Traders, Not Investors, Fueling This Stock Rally: NYSE Chief
* Friday April 17, 2009, 10:55 am EDT
*
Buzz up!
* Print
Related:
* NYSE Euronext, Inc.
Wall Street's stunning six-week rally has been fed more by traders looking to take advantage of quick swings in the market than investors with a long-term view, NYSE Euronext (NYSE:NYX - News) CEO Duncan Niederauer told CNBC.
Related Quotes
Symbol Price Change
NYX 21.86 +0.11
Chart for NYSE EURONEXT
{"s" : "nyx","k" : "c10,l10,p20,t10","o" : "","j" : ""}
Because of that, the rally likely is to run out of steam as low volume eventually comes back to the bite the market, he said.
"It feels to me we're in a trader's market and not an investor's market," Niederauer said in a live interview from the exchange floor.
Markets are likely to near their March lows after an upswing that has sent the major indexes more than 20 percent higher, he said.
"The volume in March hasn't convinced me that it's the kind of volume that you need to see to believe it was the real beginning of a turnaround," he said. "Instincts tell me we're going to retrace one more time and the rally I believe is the summer rally."
Long-term retail investors--with a three- to five-year time line--remain concerned that the rally is merely a bear-market bounce, and uncertainties in corporate health and the economy still pose dangers, he added.
"I think the real-money investors are still watching because I don't think the fundamentals are in place yet where the people feel like they can do good fundamental homework," Niederauer said. "So the feeling I've got talking to a lot of investors is they're still watching and waiting."
Niederauer called the current rally "too much, too soon," and said investor confidence remains fragile.
"There's no doubt that a lot of the ... equity investing attitudes have been damaged and I think it remains to be seen whether that damage is irreparable," he said. "They're certainly not just going to come running back."
Look at the long term charts. These decade long secular bull and bear markets are a recurring theme. Your investment strategy should be appropriate to the environment.
>"It feels to me we're in a trader's market and not an investor's
> market," Niederauer said in a live interview from the exchange floor.
Quant traders and algo trading is destabilizing because of TRADE SYNCHING! as more and more volume is traded with these techniques, the markets will destabilize more and more. no strategy is safe against the quants and the program traders. TRADE SYNCHING IS DESTROYING THE TRADITIONAL AUCTION PRICING MECHANISM ACROSS THE BOARD! the rest of the market is beholdin to the new game players. this is the new order. hold on to your hats, things are going to get very interesting.
One method I find useful is to identify stocks using fundamental analysis. Identify a sell stop (i.e. 15% below the initial buy price) as downside protection. I then sell 50% of my position if it appreciates 25% (sell target) and buy at every 10% pull-back. Continue doing that as long as you have faith in the stock on a fundamental basis.
This ratcheting action at the portfolio level builds wealth buy imposing a disciplined approach to selling and buying stocks which you pick by using fundamental analysis.
This method does not work at the portfolio level - you cannot use it as a market timing model (i.e. to be in or out of the market). It seems to work at individual stock level. I use it for stocks in which I have a long term commitment and still have faith i.e. companies such as MON, PG, JNJ, PFE, NVS.). It keeps you out of trouble ie buying them at the top and selling at the bottom.
The author does not understand that traders (institutional or individuals) are driving the wild swings in some of the stocks and long-term investors (quant or fundamental) are playing at the sidelines. They can't make sense and its better to trade in what one understands.
I think trying to blame volatility traders for this downturn is looking in the wrong place for the criminals hiding in the financial system.
www.bloomberg.com/apps...