Revenge of the Nerds - 05/10/10

 
Repeating for emphasis.

 

"Those nerds are a threat to our way of life."

-- Stan Gable (Ted McGinley), Revenge of the Nerds

Last Tuesday in "There Is No Business Like Mo Business," I issued a warning signal and pointed critically toward the potential effect of high-frequency, computer-driven trading. I concluded that if we don't kill the high-frequency-trading quant funds, they will kill us, and they almost did on Thursday.

On Friday in "Kill the Quants Redux," I suggested that he high-frequency-trading nerds had taken over the asylum on the previous day and were completely responsible for a quick 650-point drop in the Dow Jones Industrial Average.

I would like to start this week by repeating Friday's opening missive - as it bears repeating:

    One possible explanation for some portion of the recent large and random moves is the proliferation of momentum-based, high-frequency trading accounts and hedge funds.

    While the role of the traditional stock investor is to assess the net present value of a corporation's earnings and share price, many quantitative funds deride the notion of fundamental value (and ignore net present value calculations) in favor of worshiping at the altar of price momentum. The momentum-based approach, which is generally auto-correlated, tries to find repeating patterns and generally extrapolate trends by going long what is in favor and going short what is out of favor.

    It wasn't always this way. For some time, most quant funds attempted to be long value and short mis-value -- some still do -- but over time, many of their computer models changed into momentum-based programs, the purpose of which is to exploit a trend in motion.

    Money (especially of an investment kind) goes to where it is treated the best, and the quant funds have been getting a lot of the marginal cash flow into hedge funds over the past several years. As such (and given their high-volume methodology), an increasingly large percentage of the trading on the NYSE is quant-program-related; by some measures, these strategies account for between 50% and 70% of daily trading volume.

    The net of this is that quant funds control a lot of capital, they increase volatility (in both directions), and their investment style attaches little or no value to fundamentals; instead, they utilize algorithms that worship at the altar of price momentum.

    By exaggerating broader market moves as well as individual stock price moves, quant funds might be inflicting more damage than good in the efficient pricing of equities.

    It's fine and dandy when stocks are rising and the "machines" distort the moves both in scope and in duration to the upside, but, as I witnessed vividly when portfolio insurance was a disruptive force in the stock market massacre of October 1987, those distortions can and will occur in either direction.

    Computer-generated market programs almost always end up badly for the markets, but for now, they are adding to the fireworks and to the festivities.

    As the wise man once said, "This too shall pass."

    As Grandma Koufax (an admirer of Ethel Merman) once said, "There's no business like mo business."

    I say, Kill the quants ... before they kill some of us!

    -- Doug Kass, The Edge "There Is No Business Like Mo Business"
On Tuesday, I wrote ominously about the role of high-frequency, computer-driven trading. I concluded that if we don't kill the quants, they will kill us, and they almost did on Thursday.

Yesterday there was little new news over there (Greece). Moreover, other credit and money market spreads failed to indicate a deepening problem -- for instance, the Libor/fed funds spread, a measure of the willingness of banks to lend, stood at only 0.14%, below its long term average of 0.32% and below the peak level of 3.5% at the height of the credit crisis). It was not a fat finger that caused a market panic. The quants and their computer-generated market programs were directly responsible for the out-of-body market experience in which the Dow Jones Industrial Average dropped nearly 1,000 points. Stated simply, their rapid order trading methodologies seized on the market's initial decline and overwhelmed a system that was unable to provide order and stability.

One has to ask, once again, where the SEC has been on the subject of quant trading, but I suppose -- similar to the Madoff fraud, the damage done by derivatives, and so on -- that noble institution (and our politicians) will not address the issue on a timely basis until after the horse is out of the barn and after the damage has been done.

So, for now, we sit back as the tail wags the dog, as we watch the inmates take over the asylum.