The New Stock Market: Obscenely Volatile, Perfectly Inefficient And It Only Gets Worse

 |  Includes: DIA, QQQ, SPY, VXX, VXZ
by: Nathaniel Crawford

In 2001 a revolutionary study was conducted by Professor JD Farmer of the Sante Fe Institute regarding how stock markets evolve. Initially, there was nothing new about this simulation; countless other finance and econ professors had performed similar exercises. All of the models assumed rational characters acting in a rational market. Surprise, Surprise! The result was a more and more efficient and less volatile market as the rational participants eventually closed the gap between fundamental value and price. These kind of models seemed to confirm that the market was indeed efficient and getting more so everyday.

What made Farmer's simulation was the composition of his characters. He created three different kinds of actors within the simulation: the rational agent, technical traders, and seasonal traders.

Rational Agents----These market participants are the perfect rational agents. They buy if the stock price is below fundamental value and sell if the price is above fundamental value.

Technical Traders----Each technical trader was given a random trading strategy based on stock price movements. These traders would each be given a set amount of money to start with. The basic idea was that these traders would keep trying new trading strategies. The ones that worked would be replicated, and those that failed would go bankrupt.

Seasonal Traders----These market participants made buying and selling decisions in an alternating pattern.

The results, summarized in Beinhoecker's Origins of Wealth, were startling:

At first, things went according to Traditional Theory. Initially, the technical traders didn't have much money and so they didn't affect the price much. But they quickly picked up on the oscillating pattern, started to arbitrage it, and, as they did, started to make a lot of money. With success, they started making bigger trades, which in turn began to affect the price. After some time, Farmer began to see the oscillations dampen as the traders arbitraged the inefficient pattern out of the market and brought it closer to the fundamental value. After five thousand periods had passed, the oscillations were virtually gone, and the market looked as if it were rapidly approaching perfect efficiency. But then, volatility suddenly exploded, and prices began to move chaotically. What had happened was this: as the technical traders became richer, their trades became larger, and the large trades started introducing their own movements into the price. These movements created opportunities for other technical traders to try to arbitrage the patterns created by their fellow technical traders--when the technical had finished lunching on the seasonal traders, they began to feed off each other!

Below is a chart from the simulation.

Click to enlarge

After reading the above summary and accompanying chart, go back and replace the term technical traders with HFT bots and quantitative hedge funds. This is the current state of the stock market. The US and world financial markets are now dominated by these market participants. Since many of these trading strategies are nothing more than glorified momentum chasers, fundamental value plays little to no role in determining market prices. This would account for the explosion of non-stop volatility apparent in today's market.

When considering this idea, the obscene and seemingly bizarre price movement in oil price looks logical. From 2002-2008, crude oil went from around $27 all the way up to $147 despite the fact that there was no global shortage. Then, from Aug 2008 to Jan 2009 the price of oil declined to an unthinkable $30. If this was not outrageous enough, the price of oil increased back up to $110 by May 2011. Anyone who participates or trades in the oil market will tell you that demand/supply changes could not possibly account for these wide fluctuations in price. It was the result of a market controlled by HFT algorithms, quant funds, and momo traders. Instead of focusing on value, these market participants engage in predator behavior to take money from weaker traders. This dynamic creates wild price changes. which have nothing to do with reality.

Some fundamental investors will counter with "so what, in the long-term value always prevails." Unfortunately, the results of the study show that the gap between price and value can last for years--possibly decades. This study should strike fear in any fundamental trader as it means that Warren Buffett's buy and hold trading method is no longer a sure thing. That value stock you bought may indeed be trading below its intrinsic value, but that does not mean the market will close the gap between value and price anytime soon. In fact, you may become an old man waiting for the market to finally reach this equilibrium.

The Bottom Line: My contention is that the market has already reached perfect efficiency during the 1980-2000 Great Moderation period. We are now in the stage where volatility and market inefficiency explode as technical traders (e.g. quants, HFT, and momo chasers) determine price, leading to wide gaps between value and price. No longer do you have people at least trying to determine fair value for stocks. Instead, you have prices which are completely dissociated from value and determined almost solely by the latest technical or quantitative algorithms. The momo traders will then simply exaggerate the move by jumping on board for no other reason than price action.

Investment Implications:

  • While it is easy to claim that fundamentals now mean next to nothing, this would not be completely true. To make money in this new and evolving market, you still need to pay attention to fundamentals, but remember that the stock market is not driven by fundamentals. The market will vacillate wildly on the upside and on the downside creating large opportunities for speculators and investors.
  • Expect high volatility to continue for the foreseeable future. This goes against the traditional concept that the market should become less volatile as a result of greater market efficiency. You will often hear from the academic crowd that the 2007-2008 financial crisis was a 1 in a hundred year event which could not be predicted and will not likely occur again in our future. This concept is untrue; indeed, if the Farmer model is correct, we are likely to see a similar crisis or price bubble multiple times in our lifetime.
  • Risk management remains paramount. In a market where value only accounts for a fraction of the total movement in stock prices, investors can no longer assume that prices will eventually revert to fundamental value. Stop-losses are a requirement to limit risk. See Trading Lessons from Jesse Livermore
  • The market is dynamic and ever changing. There is nothing set in stone which says the market has to follow value. In a world where HFT bots and quants are king--they set the price of stocks regardless of the true value. This discrepancy can last far longer than most buy and hold investors could believe. Don't fight these new market kings. The only thing you can do is respect them and understand that they have trillions of dollars supporting these strategies. If you fight them, you will lose your shirt and then some.
  • In conclusion, the market is becoming more inefficient as HFT and quant traders create their own trading patterns, which cause massive distortions within financial markets. As the market ecosystem evolves, the weakest traders (real people) are increasingly seen as prey by the quicker and physically fit HFT algorithms.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.