A Blog by Jonathan Low


Aug 25, 2017

Is Technology Increasing Capital Market Inefficiency?

Technology was supposed to make markets even more efficient by reducing the 'friction' which investors' emotions, information asymmetries and randomized events can cause.

But it is conceivable that the trend towards passive investment strategies is stimulating artificiality in pricing through the computerized search for optimization by huge, market-moving funds. The question is what that means for management, their market-related compensation and the future of the traditional enterprise.

After all, what is value to a nano-investing algorithm?  JL

Doug Kass comments in Real Clear Markets:

The growing popularity of passive investing (ETFs and quant strategies such as volatility trending and risk parity) has produced artificiality and inefficiency in prices. Machines, algorithms and rebalancing of ETFs are exacerbating growing daily price changes. It is index driven rather than stock driven. This is not a product of investors rushing to buy individual stocks. It is big funds and computer programs buying futures, index ETFs and derivatives of the indices.
In "The Hitchhiker's Guide to the Galaxy," author Douglas Adams writes that "we demand rigidly defined areas of doubt and uncertainty." Nowhere has that become more obvious than in the recent action of stock prices.
Traders and investors now face a delicious ambiguity.
After an extended period of limited daily price changes, volatility and uncertainty have returned to our markets. (The) 25-handle move up in the S&P 500 Index continued the pattern of uncertain and almost-random daily large price moves.
In large measure, machines/algorithms and the rebalancing of ETFs are contributing to and exacerbating the growing daily price changes seen in the last month. Yesterday, in support of my view, Rev Shark wrote the following in "Here's What's Driving This Spirited Rally":
"One thing the business media are missing in the coverage of today's energetic rally is that it is primarily index driven rather than stock driven. This move is not a product of investors rushing to buy individual stocks that have sold off recently. It is primarily big funds and computer programs buying futures, index ETFs and various derivatives of the indices.
The easiest way to spot an index-driven market is when the leaders are primarily the big-cap names that are the major components of the indices. Apple (AAPL) , for example, is the "Big Kahuna" of the indices and is outperforming with a gain of 1.6%. Other large-caps such as Alibaba (BABA) , Amazon (AMZN) and Alphabet (GOOGL) are also doing better than the averages."
As I wrote five days ago in "Should Investors and Traders Be Reactionary or Anticipatory?," truth in investing to me is best determined by intrinsic value, not price. In other words, renewed volatility should be embraced. And when the difference between one's determination of the intrinsic value relative to current share price widens, one should, without emotion, move into action. As I wrote:
"Should investors and traders be reactionary by following and trusting stock prices, or should they be anticipatory and take advantage of the difference between stock prices and a derived calculation of intrinsic value?"
To me, one of the most difficult parts of investing over the last nine months has been holding on to a bearish market view in the face of rising share prices.
Throughout this period (and longer), I have had a continuing and respectful debate with Rev Shark on the merits of being anticipatory versus being reactionary.
Rev Shark, a technically minded fellow, believes "price is truth" and has adopted a very profitable trading technique and career that follows and does not anticipate price trends.
By contrast, I am fundamentally minded and I believe intrinsic value is truth, not price. My investing technique relies on my calculus of fair market value as determined by a set of probabilities. To me, the discount/premium to the calculation of intrinsic value changes daily. The larger the discount, the more attractive the long, and the larger the premium, the more attractive the short. In other words, unlike Rev Shark, I grow more confident in larger long and short weightings despite prices that may be going against my investment positions...
It can be debated which is the proper strategy. While Rev Shark has his methodology and I have mine, I believe they can coexist. As it is, we provide subscribers with a menu of thoughtful tactical strategy and different ways of looking at the markets.
... Most investors and traders should consider both the existing price trends and their assessment of fair market value.
That said, during periods of clarity in price trends being reactionary (like Rev Shark) may prove to be a more effective strategy.
However, my view has been that the growing popularity of passive investing (ETFs and quant strategies such as volatility trending and risk parity) has produced an artificiality and inefficiency in prices -- a non-truth, so to speak, that has been materially unrecognized by many.
As stock prices, catalyzed by animal spirits following the November election, began to ascend, it was my view that prices began to leap well ahead of my calculation of intrinsic value. A second leg of advancing prices seems to have occurred as "machine spirits" replaced those animal spirits. Share prices, I thought, then moved even higher relative to intrinsic value. (Remember machines/algos buy high on strength and sell low on weakness -- it is the nature of those beasts!)
My approach, which appears on its face simply to be looking for tops in shorts and bottoms in longs, is really not looking for near-term inflection points. Rather, it is a strategy that anticipates the inevitable adjustment in the spread between real-time stock prices and the calculation of intrinsic value.
My approach is based on my perception of stock price inefficiencies that occur continually through a plethora of influences.
I recently concluded, based on my analysis of the S&P 500 Index, that the potential downside exceeds the potential upside by a factor of four times. Though stock prices were trending higher and as recently as a week ago were at all-time highs, my view of the very unattractive reward vs. risk and the widening of stock prices relative to intrinsic value caused me to be more aggressive and anticipatory rather than waiting for a price trend change; it is the essence of my approach to trading and investing.
I get more bullish or bearish based on the spread and not on the basis of price trends."
In the aforementioned post I explained how I plan to implement my strategy against a more uncertain and volatile backdrop:
"In recognition that there is more uncertainty about market outcomes and that there are agents such as ETFs that rebalance daily, producing extreme and often artificial price outcomes, my tactical approach has been to average into both my longs and shorts regardless of conviction. For example, let's say I have a target 3.5% of my entire portfolio for an individual long holding. I typically will purchase a 1.5% initial stake and average in as the relationship between current share price and intrinsic value widens. Similarly, I typically will target 2% of the entire portfolio for a short holding. I typically will short a 1% initial stake and average in as the relationship between the current share price and intrinsic value widens."
In terms of selling longs and covering shorts the same approach applies. Even though the price trends may persist as the spread between share price and my calculation of intrinsic value narrows, I will reduce my longs and shorts.
Examples of longs that I recently have reduced -- the share prices of which have approached my intrinsic value calculation -- are Hartford Financial Services Group Inc. (HIG) and DuPont & Co. (DD) . Examples of longs to which I recently have added, where the share price has fallen further relative to the intrinsic value, are Dillard's Inc. (DDS) and Twitter Inc. (TWTR) .
Examples of shorts that I recently have increased because the share price has widened relative to the intrinsic value are long ProShares UltraShort QQQ (QID) and ProShares UltraShort S&P 500 (SDS) and shorts of SPDR S&P 500 (SPY) ."
Bottom Line
"And I said, 'That last thing is what you can't get, Carlo. Nobody can get to that last thing. We keep on living in hopes of catching it once and for all."
--Jack Kerouac, "On The Road"
It is time to make the market's uncertainty and volatility our investment management friends!
There is an antidote to volatility. Embrace uncertainty by determining what the intrinsic value of a market, sector or individual stock may be. As the difference between that value and the current share price widens, fearlessly capitalize on the discrepancy by either shorting/selling or buying more stock.
In order to practice this approach of capitalizing on abrupt and random price changes, one must be emotionless; a stronger sense of intrinsic value will embolden the trader and investor.
Here is how this approach manifests itself in my recent trading/investing:
* I covered some inverse ETFs (short positions) in wooshes down and added back in rallies higher.
* I added to individual long investments in wooshes down and added to some of my favorite shorts in rallies higher.
* Regardless of my ursine overall market view, I was willing to reduce my net short exposure during the recent downdrafts and take back up that net short exposure during the rallies.
This approach requires fearlessness in an uncertain world filled of numerous outcomes, many of them adverse -- for, as Woody Allen once wrote, "I took a test in Existentialism. I left all the answers blank and got 100."
The bottom line is that heightened volatility provides opportunity to those traders and investors who have a sense of value.


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