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Thursday, March 10, 2016

On the robotification of markets

Polemic's Pains - algo isolation driving markets bonkers. Quoting the majority of the post for better context, since you lazy farts never bother clicking through:
The markets since January have, I would strongly suggest, been more driven by the price of other financial instruments than they have by changes in the underlying economy. Oil falling and rallying by 35% has not been because of a 35% change in physical supply and demand but on the expectation of what may happen. The moves in equity prices oscillating -20%/+10% have not reflected actual changes in profitability of companies but rather expectations based on moves in credit, oil and interest rates. The sharp move up in metals hasn’t been caused by smelters suddenly consuming masses more, but the change in expectation driving those who had borrowed to short to buy back to cover and those anticipating future demand rises to buy and store.

All the while the new driving force in the markets, algorithmic driven funds, look at the price actions around them in the finance tank and follow the trends. This whips up more moves in the finance world which leads to the algos noticing that the real world data is having smaller impacts relative to the actions of prices around them. They then rebalance the weightings of real world factors and focus more and more on price correlations. This drives the disconnect between finance and economic reality so far that the tank of finance is in danger of spawning off as its own budding universe of introspection and self importance leaving reality far behind.

Is this not what we are seeing? The year of 2016 has been relatively shock free as far as new issues go yet markets have been bonkers. It’s been like driving a car with loose steering linkages, with the steering wheel being swung hard left and right to just keep going in a straight line.
I agree that markets have been Little Miss Piddle-Panties for a long time now - since the August puke at least.

But as for algo-driven insanity? I'm sorry, I don't see the problem.

Stocks (and bonds and etc) have underlying values, so if algos are driving prices away from their underlying values, then they're producing an exploitable beta and you can capture it for yourself. All free candy gets eaten: isn't that a fundamental law of markets? The >10% discount to underlying of QQQ we saw in late August got gobbled up pretty quick, didn't it?

And if there are no smart algos out there already hunting and eating the stupid algos above, then Wall Street must not have hired as many physics Ph.D.s as everyone says they have. What science geek working in an algo shop wouldn't want to say "yeah, I'm the guy who designed the first hunter-killer algo"? No matter, Buffett'll do that work himself.

Worst you're suggesting is that people should use lower trailing stops. Or maybe keep more cash on hand to exploit crazy intraday ultrapukes.

But even that suggests there are large bowls of short-term free candy available in a market going up slowly long-term. That's also free candy waiting to get eaten.

Sure, the stock market is a cybernetic deathtrap: no properly engineered machine would have this many positive feedbacks built in unless you were looking to use it to nuke Hiroshima. But profit motive is the ultimate stability generator. It's only when the value of the underlying gets hammerblow torqued, like 2007-8 when investors woke up one day to find they'd been defrauded by the financial industry, that the market becomes unstable.

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