I once hired a guy for a fund I was partner in. He was a proper old school equity investor. He'd fly around the world to different countries and visit businesses. He'd think about each country's prospects, each industry, and each company. He'd meet withe the CEOs and look them in the eye, and ask them whether his company was gonna make money. I shit you not. He's come back to the office and share his thoughts on why one country was good, why this industry, why this business. It was a different story each time.
Another guy I worked more closely with on a fixed income desk. We'd think about different countries, their bonds, their IR rates, swaptions, etc. There's be some global stories inevitably, but a lot of local ones too and we'd chat about what to do in our trading book.
Then there was quantitative FX trading, another one of my projects. We'd look at things that affect currencies, patterns in the prices, anything you might imagine arrives as a live feed. And we built the infrastructure to trade the regularities that we found. Quite a lot of research and execution infrastructure. But at the end of the day, the computers are doing what? Looking at a variety of information and judging what will happen. Just like my two colleagues.
Fast forward to the last few years. Pretty much every conversation I have with anyone in the investment business talks about one thing: QE and zero rates. There's only one thing that matters for everything now. When interest rates are really low, what happens? Everything is worth buying. Buy houses, buy stocks. Buy them in the developed countries, buy them in EM. Sell options.
What used to be a conversation containing rates as an ingredient has become a conversation only containing rates.
People, and computers which learn what worked for people in the recent past, have gone from a rich market conversation about many things to one about just QE.
It will be interesting to see what happens in the near future. I can't think of a lot of bubbles that were deflated in a controlled manner. And I also expect more differentiation in equity debates. Company does this, industry does that.
> People, and computers which learn what worked for people in the recent past, have gone from a rich market conversation about many things to one about just QE.
So are you saying that in the past N years since QE and 0 rates, the parameters that define which assets/resources to buy/trade have gone from wide-ranging (e.g., "We'd think about different countries, their bonds, their IR rates, swaptions, etc"), to singular (e.g., "...has become a conversation only containing rates.") ?
How does this tie back into the "herd-like behavior" comment? Are you saying that every algo trader is only focusing on rates because that (more so than anything else), is determining where to allocate capital?
>the computers are doing what? Looking at a variety of information and judging what will happen
Probably but not necessarily. That code which is explicitly understood and written explicitly to weigh information to choose outcomes certainly is.
But were complex neural networks are extensively involved, they become a black box. In markets where gains could be maximized by cooperation, those systems that find ways to cooperate with other systems outside their organization will eventually be chosen and become the dominant. Chosen purely from their ability to get better results.
Even if completely isolated, signaling is not impossible. A straight forward technique would be to use transactions to communicate in the same way bridge players do.
So potentially software could outperform humans for at least two reasons: better and faster analysis of data. But also doing things humans are unable.
In my experience as a quant dev for various traders , neural networks are almost never used for trading, or if they are they're very limited in their application.
But many traders will claim their use because they are obtuse and impressive sounding.
One PM once described it as "machine learning in the streets, linear regression in the sheets".
As the article points out, passive funds, which have become a dominant force in the stock market, own the same stocks as everyone else in the same proportion.
When passive funds as a group have net outflows, all their holdings must be reduced in roughly the same proportion. But passive funds as a group cannot reduce their holdings by selling stocks to each other! It's impossible to take water out of a boat by scooping water from one spot and pouring it back into the same boat in some other spot!
Therefore, to reduce holdings, passive funds (or their broker-dealers) necessarily must find other -- i.e., non-passive -- buyers willing to take those stocks at some market-clearing price. Alas, everyone else, in the aggregate, also owns the same stocks in the same proportion.
Potentially, this can produce temporary imbalances between passive net sellers and non-passive net buyers that get corrected via declines in price. Passive net sellers, being price agnostic, do not care; they're on automatic.
A lot of the attention on the stock market is focused on the short term (i.e. panic sells or a flight to safety in reaction to quick emotional events), but I wonder what happens when this dynamic plays out in the long term.
Right now, the pool of people putting money into the market has been steadily increasing as Millenials enter the workforce. Boomers are retiring, but not really in large numbers yet, so the overall number of folks saving for retirement has been continually increasing since Boomers started entering their prime earning years in the early 1980s.
However, the peak of the Boomer years will soon start entering retirement soon (~2020) while the early Boomers are starting to die off. And the generation after Millenials - who will start comprising the workforce in 2020 - is much smaller than the Millenial generation. There are fundamental issues with demographics that can't be papered over by financial engineering: a smaller working-age population supporting a larger dependent population (absent massive technological advancement in care) = lower standard of living for everyone.
Demographically, this would play out as a generation-long bear market, but markets tend to correct as soon as everyone adjusts their expectations for the future. That implies a sudden and massive crisis at some point with stock market levels correcting to the yields and prices of the 1970s, adjusted for inflation. That would imply an S&P 500 of about 370 (down ~95%) and interest rates in the 10% range.
> a smaller working-age population supporting a larger dependent population (absent massive technological advancement in care) = lower standard of living for everyone
On average, assuming nothing else changes. In reality, we have the levers of immigration and workforce utilization (e.g. making it easier for ex-felons or non-violent drug convicts to re-enter the workforce) to juice labour inputs. And we have education and R&D to juice productivity. On top of that are random factors like natural resource utilization, falling energy and material intensities of GDP, et cetera.
> That would imply an S&P 500 of about 370 (down ~95%) and interest rates in the 10% range
One cannot so neatly connect demographics to interest rates, let alone the S&P 500. Demographics map to certain consumption sectors (e.g. durables) very well. They map to others (e.g. luxury or entertainment products) quite badly.
To illustrate one of the many confounding variables between demographics and stock prices, consider what a small shift in asset allocations in a single generation from real estate to equities would do to prices.
In such a horrific scenario, I imagine the stocks of companies with low-duration free cash flows (i.e., generating profits in the near future and trading at reasonable multiples of those profits) would hold up the best, because they can pay greater dividends, buy back more shares, be more likely to go private at a premium, etc. As for the stocks of companies with high-duration cash flows (i.e., companies for which the majority of profits lies far in the future, trading at optimistic multiples of those distant profits)... I imagine they would suffer the worst declines.
There is an underlying presumption here that US stock market and investors live in the US, or are otherwise correlated with US demographics. Historically this is not true. International investors make up a sizeable part of the investors, and within the US investors the very wealthy are a disproportionate part of the market.
The same phenomena is playing out throughout the developed world and even in much of the developing world, though. Europe has even lower birthrates than the U.S, China had a huge baby boom in the 50s and 60s followed by a huge baby bust in the 80s under the One Child Only policy, and Japan has been in this situation since the 90s.
What would reverse this, internationally, is if the high-youth countries of Latin America, the Middle East, sub-Saharan Africa, and rural India could be rapidly integrated into the global economy. There are large political, cultural, and educational barriers to this, though.
Some did. Peak births per year happened in 1957, and during the boom, total births were skewed toward the latter end of the 1947 to 1965 period. In 2017 the median retirement age in the USA seems to have been 62, I can only imagine that number will have increased over 2018 and will continue to increase as the markets stagnated. That would put us just now approaching peak retirement rates. Add to that the fact that investment advisors still seem to want to wait most people toward equities for their first few years of retirement (at 60, your investment horizon is still 20 years out these days...) switching fully to more fixed income and few years in, I think that all is a recipe for the rotation just beginning.
"...a smaller working-age population supporting a larger dependent population..."
This describes Japan for the past decade or so, right?
Also, are you saying the standard of living would regress back to the 90's/80's/etc., or that growth in the standard of living would be curtailed significantly?
It'd depend on industry. We wouldn't suddenly lose the technological advancements of the last 40 years - we'd still have cheap TVs, cheap computers, mobile phones, the Internet, etc.
However, sectors where productivity hasn't risen that fast - like health care, elder care, mental health services, natural resources, etc. - will encounter sharply rising prices as there are too few workers to provide services to everyone who needs them. The market is a way of allocating resources to those who are willing to pay the most - so those with resources will still be able to afford them, but will end up liquidating a lot of their investments for it, while those without assets will just have to go without. In the process, the exodus of cash from financial markets to health & elder care will drag down asset prices in general. It'll be a good time to put money into the market, but a bad time to have money already in it.
You're saying that the rate of growth in the standard of living would be curtailed, and that the degree of curtailment would be sector dependent? If so, then I definitely agree.
passive funds hold a disproportionate amount of sp500 like indexes. if that was the only explanation, those would have to fall always much more in price than all the rest.
Realize it doesn't meet the true technical definition, but more the idea of passing the buck (so to speak) and someone getting hit pretty hard, in an inevitable / unavoidable sorta way. Also, because this also (to me) feels less like investing and more like a timing game.
>> As the article points out, passive funds, which have become a dominant force in the stock market, own the same stocks as everyone else in the same proportion.
THIS. This is how it works. They also have similar basis prices for their positions, and similar pain thresholds. It's not a big surprise that when Institution XYZ reaches its' pain threshold and stop loss orders are used, a few more dozen Institution ABC, DEF, and GHI hit theirs also! This looks like a "huge selloff" on a chart, but it's just the same event being experienced by multiple institutions near the same point in time.
Passive funds have no pain thresholds which force them to sell. Investors in them may. But that’s a difference in how individual investors’ risk tolerances are abstracted to broad market pricing, not a change in those risk expressions themselves.
I disagree, I'd argue that exactly 4 times a year, passive funds must sell, and must buy again. Contract expiration dates cause huge volumes of activity from so-called "passive" funds. The seconds, minutes, hours, and (occasionally) days that elapse between rolling out from current month to forward month contracts are all about the fund managers pain threshold. The exception to this rule is if your fund has governance specifying that rollovers have to happen ASAP(as in, as each <N> contracts are sold from the current month, <N> forward month contracts must be bought before repeating the process), which is not common.
edit: Sometimes I'm blinded by the part of "market" I operate within, which is the commodity futures market. I could be(and likely am) completely wrong when you apply this to the securities market, which I am less familiar with.
How is that any different from previous bear markets? I swear I remember reading the same analysis in 1987 after the crash.
Human behavior (even human-programmed behavior) is pro-cyclic. Everyone wants the same stuff and makes the same decisions with the same input. I don't see anything notable about this market cycle as compared with previous ones at all, only the jargon is changing.
It's not any different other than the speed it happens at. 20 years ago it would have taken minutes/hours for some of the drops we've seen to materialize. Now you can watch the NQ drop 100 points in less than 5 minutes, 20 years ago that would have taken hours, possibly all day. People had to wait on quote services via satellite, telephone calls to their floor traders, or actually be in the pits during the selloffs. Now it only takes us a couple seconds to connect our device of choice to our trading platforms. Market makers stop providing liquidity during these sell-offs much faster than they could 20 years ago.
> 20 years ago it would have taken minutes/hours for some of the drops we've seen to materialize.
Twenty years ago was 1998. Ten years before that, Black Monday was faster and more vicious than anything we've seen since. It remains "the largest one-day percentage decline in the DJIA" [1].
Not really sure what your point is. Cycles always happen for the same technical reason - more buyers than sellers lead to rising prices and more sellers than buyers lead to falling prices. Understanding what leads to these imbalances in buying and selling is the more interesting and more difficult part and the details tend to be a bit different for every cycle. Most people find these details interesting and for some people, it is their job to understand these details. The abstract idea that herd behavior is what moves markets is not that useful unless you understand exactly which herds are moving which markets and how they make their buying and selling decisions.
> Not really sure what your point is. Cycles always happen for the same technical reason
Pretty sure that was exactly my point. I'm sure someone finds the behavior "interesting", but if the same thing is happening for the same reason, I'm arguing those details that everyone finds "interesting" aren't "important".
Okay, well I think we disagree then. Most people who follow the markets know that markets are cyclical, but knowing if you're in the beginning, middle or end of the upswing or downswing portion of the cycle is what most people care about. Knowing the details are the only way you could even have a chance of correctly making these calls.
> Knowing the details are the only way you could even have a chance of correctly making these calls.
That's voodoo thinking. "OK, all those other times everyone was wrong about this. But this time we have new jargon, so we can figure it out!"
Nothing in the linked article (or anywhere else) gives you the magic you want. This is just a new way of explaining long-settled ideas.
This is like trying to debug a linked list bug via disassembly. "OK, fine, it was a bug before on x86, but look, now it's compiled for RISC-V and uses entirely different register schemes, so this time it will work!"
The person you're replying to is telling you the truth - imbalanced delta for buyers or sellers means rising or falling prices. There is no magical equilibrium, and if there was, there would be no profit.
To explain it a step further... at this moment in time, every private and institutional investors stopped selling APPL...I can still buy a share, likely thousands of them... from the market participants that are always there: market makers. When you make a "bad call"(like selling into a rally), a market maker is likely on the other end of your trade, and they will profit from your "bad call". Now the inverse also applies, often times a market maker is taking the other end of your trade that is a good(profitable) trade for you. The market maker isn't losing though, they are just playing the odds. They are convicted that for every losing trade they take out of obligation(as a market maker), they are going to take 2 or more winning trades. They also operate with trade costs much lower than you or I(ie retail investors) have access to.
That was more reply than I originally intended to write...but you have to understand this(or fail at profitable trading). There is no equilibrium, and there are parties(market makers) ensuring that there never will be. That is their job, to create a state of constant liquidity, even if buyers and/or sellers individually are unwilling to play.
Your understanding is exactly backwards. Market makers provide the "magical equilibrium" by bridging supply and demand across time.
> and if there was, there would be no profit.
Wrong again. Even with infinite shares on the bid/ask, there's still a spread for market makers to collect.
More generally, what exactly do you think your comment proves? If a retail investor buys the sole 100 shares at top-of-book, the price (mid) moves up, but there's one buyer and one seller. Where's the "delta"? And if a big hedge fund buys 100,000 shares from 10 market makers... 100,000 shares demanded and 100,000 shares supplied. Magic!
You're arguing against an accounting identity. I know what you're trying to say: what moves prices is relative eagerness of buyers and sellers. You're just too inexperienced to be able to explain it.
The "market" is more complex than a single stream of matching buy and sell orders at specific price levels. For any given asset, there is an "order book" containing the quantities market participants are willing to buy/sell at various price levels. Lots of people coming in to buy at "the market price" eats away at the selling side of the order book, raising the market price level.
Perhaps buyers nibble at the ask. Perhaps a big order slams through. Or perhaps the posted liquidity is canceled without any trading having happened. Whatever the case, the number of shares sold is exactly equal to the number of shares bought.
Yes, perhaps I should have chose my words more carefully. When more people want to buy than sell, prices rise. When more people want to sell than buy, prices fall. The exact details of how this happens vary from market to market but in general this is how it works. For every trade there has to be a buyer and a seller. The imbalances occur in the buy and sell orders.
But to a first approximation, the numbers are the same! If anything, some of the biggest moves happen when a single (big) buyer or seller is active. It’s all about the prices participants are willing to trade at, not an imbalance of one group vs another.
I would think it depends on what scale you're looking at. It is pretty obvious that if one guy takes out a large chunk of the order book of one security, over the course of seconds, on only one side of the market, the price is going to move. If we're talking about the S&P 500 dropping over the course of a few months, I think it is accurate to say that those who want to sell are outnumbering those who want to buy.
Many (if not most) quantitative hedge funds are dollar neutral, which means they have one dollar short for every dollar long. There are typically additional constraints about having equal long/short exposure on each industry and investing style (momentum, value, etc).
So contrary to the article, most of these funds don’t take broad bets for or against the market. What they are really doing is correcting the relative valuations of each individual company by shifting bits of capital away from overpriced companies and towards underpriced ones. That doesn’t have the effect of raising or lowering broad market indices.
Now there are of course other investors who take broad directional bets on the market but those are probably more likely to be discretionary bets rather than systematic.
> Many (if not most) quantitative hedge funds are dollar neutral
Delta neutral. And this is very difficult (and expensive) to attain in real life. Most funds are long biased because it's cheaper to be long than short.
No - dollar neutral. Delta neutral is an entirely separate concept. I'm talking about equities trading (or potentially total return swaps) not options or other derivatives.
Why do you think its so difficult and expensive to attain? What do you think institutional borrow costs are? And I'm not talking about Interactive Brokers... I'd wager that most funds are long biased because its more difficult to generate short alpha - not because of the costs of portfolio construction.
Stock borrow is expensive. More problematically, dollar neutral doesn’t necessarily mean beta neutral (which is the same thing as delta neutral with respect to a broad-market index).
Sure, I alluded to the concept of beta neutral when I mentioned 'additional constraints' - dollar neutral was a simpler concept I used for a non-finance audience. I've never heard anybody use the term delta neutral outside of derivatives trading.
For the vast majority of symbols, stock borrow is cheap at institutional size.
> For the vast majority of symbols, stock borrow is cheap at institutional size
Stock borrow costs vary from symbol to symbol. The ones you want tend to be the ones you pay for. Moreover, cheap doesn't mean free. Shorting half of one's portfolio is rancidity expensive compared to buying some puts. Even that is pretty expensive for total hedging purposes.
At the end of the day, most long-short funds are not market neutral. The ones that are operate on minuscule time horizons, and are better categorized as shadow market makers than funds. (Both in their operation and fundraising mechanics, the short-term traders tending to be more likely to deploy permanent--versus limited--capital.)
To expand on pmalynin's excellent answer with an example:
Imagine you think Apple is better than any other technology company and you want to bet it will outperform other technology companies. If you simply buy Apple stock, you might lose money even if it outperforms all other tech companies, in the case that the whole market is going down. Because of the above, you need to devise a strategy that will earn you money on the difference between Apple stock and the overall tech sector stocks. Those strategies usually involve combinations of stock and derivatives and you can optimize your returns vs exposure with simple models.
The goal is to have zero correlation to the index (called beta). You’re hoping that your long assets will go up in value regardless of what the index is doing (the alpha of the stock). Similarly with your short positions, you’re hoping that they are going to go down regardless of what the index is doing. In a sense you’re eliminating “chance” by driving the beta close to zero and instead are focusing more on what actually makes the company a good investment (it’s alpha)
Because your portfolio is neutral in terms of the market/sector, but not on individual options. A good place to start is to read up on statistical arbitrage.
Actually, it works in the opposite direction. Here is why: if betting against the herd was the right thing to do, algos would learn this behavior and all algos would start betting against a big price down move. This is why algos actually reduce volatility, not increase it. And volatility is exacerbated by humans: trade wars, attacks on the fed and general erratic behavior of our president
We had plenty of algorithmic trading and years of very low volatility at the same time. If algorithmic trading increased risk of extreme events, it would have shown up during let’s say 2012-2017 years of low volatility. No, algorithmic trading actually reduces risk of extreme events such as fat fingers or extreme bets by humans. What drives volatility is macroeconomic environment.
Flash crash of 2010 was extensively investigated and no evidence that algorithmic trading was at fault was found. After that, we had some of the lowest turubulence years on record, while algorithmic trading was going on, so your theory is not supported by evidence.
There have been others. Plus there's some enjoyable literature if you're curious. Mark Buchanan has a nice blog and some links. The gist of it is that in the low latency space the ratio of players to possible strategies is too high.
if yoi try to tie low latency or algorithmic strategies to volatility, you need to be able to explain multiple years of really low volatility despite all those strategies going on.
Low volatility according to what measure? I don't keep up with the literature anymore, since around 2010/2011, but it'd surprise me if we entered some new regime. Googling for "flash crash" turns up many more examples than just the one you mentioned from 2010.
Markets are moving much faster but we’re still using the same scale on the x axis (time). We’ve seen a 4,000 point drop so far but if that occurred over a one year period we would have called it a recession. However if the market recovers in the next few months we’ll interpret this as the continuation if a 10-year bull market.
This was a healthy correction. I was expecting a bounce at $251 on $SPY but it went much lower. This is insanely healthy when we recover. Now we can have a 15-20 year bull run.
Yes, there is herdlike behaviour. But why?
Here's a little story about my investment career.
I once hired a guy for a fund I was partner in. He was a proper old school equity investor. He'd fly around the world to different countries and visit businesses. He'd think about each country's prospects, each industry, and each company. He'd meet withe the CEOs and look them in the eye, and ask them whether his company was gonna make money. I shit you not. He's come back to the office and share his thoughts on why one country was good, why this industry, why this business. It was a different story each time.
Another guy I worked more closely with on a fixed income desk. We'd think about different countries, their bonds, their IR rates, swaptions, etc. There's be some global stories inevitably, but a lot of local ones too and we'd chat about what to do in our trading book.
Then there was quantitative FX trading, another one of my projects. We'd look at things that affect currencies, patterns in the prices, anything you might imagine arrives as a live feed. And we built the infrastructure to trade the regularities that we found. Quite a lot of research and execution infrastructure. But at the end of the day, the computers are doing what? Looking at a variety of information and judging what will happen. Just like my two colleagues.
Fast forward to the last few years. Pretty much every conversation I have with anyone in the investment business talks about one thing: QE and zero rates. There's only one thing that matters for everything now. When interest rates are really low, what happens? Everything is worth buying. Buy houses, buy stocks. Buy them in the developed countries, buy them in EM. Sell options.
What used to be a conversation containing rates as an ingredient has become a conversation only containing rates.
People, and computers which learn what worked for people in the recent past, have gone from a rich market conversation about many things to one about just QE.
It will be interesting to see what happens in the near future. I can't think of a lot of bubbles that were deflated in a controlled manner. And I also expect more differentiation in equity debates. Company does this, industry does that.