Last week’s market sell-off was an eye opener for most investors, but with trading returning to normal this week, it’s likely that it’ll soon be forgotten by both Wall Street and Main Street. But for observant market participants, the “Crash of 2:45 p.m.” offers some valuable insights – like these 9 takeaways…
This is what happens when a market with no investment merit at current valuations runs out of speculative fuel:
Investors may finally be turning their attention to quaint concepts like valuation and risk.
Computerized trading, which is driven by similarly programmed algorithms, is the main culprit. Here are my thoughts on last Thursday’s crash, and how it might change things going forward:
Dan Amoss
Penny Sleuth
May 11, 2010
This is what happens when a market with no investment merit at current valuations runs out of speculative fuel:
Investors may finally be turning their attention to quaint concepts like valuation and risk.
Computerized trading, which is driven by similarly programmed algorithms, is the main culprit. Here are my thoughts on last Thursday’s crash, and how it might change things going forward:
- When the governments and central banks manufacture the illusion of an economic recovery driven by deficit spending and money printing, the faith in the sustainability of that recovery is — not surprisingly — weak. Now, after two crashes in the space of a decade, the list of greater fools is shorter. Mom and Pop investors have wisely chosen to remain skeptical throughout this bear market rally, making it very narrow and jittery, rather than broad and sustainable. After last week’s drama, I think we can forget about the widely anticipated surge in mutual fund inflows.
- Thursday’s market was one of many consequences of watering down accounting standards in the banking system in spring 2009. Poor accounting quality introduces an element of Ponzi psychology in the trading of financial stocks. In other words, if everyone owning these stocks knows that earnings are very fudge-able, and embedded credit losses are being stretched way out into the future, they’ll aggressively dump these stocks on any correction.
- Someone must hold every share of stock that’s been issued. This is why the notion of central bank money printing holding up the stock market forever is too simple. If primary dealers “repo” Treasuries at the Fed, and use the cash proceeds to buy stocks and corporate bonds, they are by definition not strong hands. They close out these trades quickly on days like yesterday. The strategy probably involves paying ever-higher prices into rising, calm markets, and unwinding violently when volatility picks up. This doesn’t make for a healthy stock market. Perhaps Congressional hearings should target the influence of primary dealers borrowing from the Fed to finance risky carry trades.
- The market has too many impatient, trend-following traders, who sell when “support” levels get hit. They aren’t buying stocks with the view that stocks are fractional ownerships in businesses on sale. Technical analysis loses its value when every technician uses the same strategies, and has similar stop losses, as yesterday showed us.
- The market doesn’t have enough patient, skeptical investors. This makes bubbles and crashes more likely. The good news is it creates buying and shorting opportunities for contrarians.
- After last week’s market gyrations, it’s becoming even more apparent that “quant,” or computerized trading exacerbates market swings. Rather than supply cash to the market during panics — and supply stock to the market during melt-ups — it appears that these funds do the opposite. Quant trading relies on the same garbage-in-garbage-out models that created such wonders as “triple-A” CDOs. The physics and math Ph.D.s who create and modify these models should apply this math where it’s actually appropriate and predictive — in engineering problems — rather than markets heavily influenced by emotion. Quants seem to know the price of everything with each passing nanosecond, and the value of nothing. We should seek to take advantage of mispricing caused by quant trading — primarily by adopting a longer time horizon for trades. The less often you trade or invest, the more time you have to think.
- Crashing markets cause everyone to have a “deer in the headlights” reaction. But it helps calm your nerves if you’re confident in the value and earnings power of the stocks you own. Only computers without an understanding of valuation and market history could have been selling quality stocks at 20-30% of intrinsic value aggressively at the 2008 market lows — which was clearly the case.
- This isn’t just in stocks. We’re seeing risk aversion in currencies, commodities, and corporate bonds. If the crash in the Euro keeps spiraling out of control, look for Ben Bernanke to set up a massive swap line with the ECB to provide dollar liquidity to leveraged speculators looking to unwinding carry trades.
- In today’s investment culture, the vast majority of fund managers don’t stay in business if they think too independently. If money managers decide to not participate in a rally because they judge the fundamentals as weak, they often get fired. A few decades of this investing culture has resulted in scary levels of groupthink. The less that fund managers can think and act independently, according to their best judgment, the less efficient the market becomes. Another way of saying “less efficient” is “more prone to bubbles.” Career risk forces otherwise rational, sober managers to buy into an expensive, rising market.
Dan Amoss
Penny Sleuth
May 11, 2010
