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Computerized Trading Takes Over The Market

Doug Kass on The Edge has written an article explaining the impact of the computerized trading on the stock market.

I have to be honest that the volatility is having a negative impact on me – and our portfolio performance. The computers are killing the stocks with earnings (selling companies with a 6 P/E that have earnings growing 27% per year and buying stocks with a 18 P/E that have earnings growing at 7% per year). Its trading that doesn’t make sense. Fortunately, its usually short-term in nature – we went through this exact thing in 2006 and it was just as painful then – and the fundamentals take over again. But slugging through it requires lots of Maalox and Ibuprofen as your stomach flip/flops and your head pounds with every illogical tick down.

Anyway, enjoy Doug’s article.

Kill the Quants
8/12/2008 6:41 AM EDT

Momentum-based funds exaggerate trends and chase winners, and they’re a big factor in this summer’s volatility.

The role of the traditional stock investor is to assess the net present value of a corporation’s earnings and share price.

By contrast, the increasingly popular 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 quant funds, which are generally auto-correlated, 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, quant funds attempted to be long value and short mis-value. But over time, their computer models changed into momentum-based programs whose purpose was 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 much of the marginal cash flow into hedge funds over the last several years. As such, an increasingly large percentage of the trading on the NYSE is quant program-related.

The net of this is that quant funds control a lot of capital, they increase volatility (in both directions) and they invest based on reasons that have little do with how much a company is worth.

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.

The role of quant funds, as Mike O’Rourke (chief investment strategist at BTIG LLC) wrote this morning, might also explain the manner in which this market will embrace a theme and then take it to the nth degree.

And perhaps the quant fund activity is behind some of the conditions that Mike has further observed today:

The June-July story was the (now obvious and often belabored) “long energy/materials & short financials/consumer discretionary” trade. Now, the story of early August is “long financials/consumer discretionary & short energy/materials” and of course, both sides are being pushed to short-term extremes. The obvious problem is that the foundation behind the June-July move was the fundamental background behind each side of the trade. We wholeheartedly believe the financials were overdone to the downside. In the same respect, we are also stunned at the willingness of investors to pay up 50%-100% from the trough lows, knowing that there will still be bumps in the road. The correction in crude has breathed new life into consumer discretionary. The same correction in energy has also taken energy and materials stocks down.

The question we find ourselves asking is whether just because one of the fundamental stories behind the theme of the early summer has reversed, have all the fundamentals reversed? Simply stated, does the correction in crude mean that the woes of the financial sector have disappeared (they have not), or that the strapped consumer has access to new capital (he does not), or that mortgage rates are not at five-year highs and set to break out (they are), or that the Americans who have lost their jobs this year have been hired back en masse (they have not)? What is the likelihood that the spurious relationship that energy/materials and financials/consumer discretionary maintained earlier in the summer due to coincident timing will continue to persist? Money in this market has a tendency to chase performance, and it’s August, so the moves tend to become exaggerated.

If I am correct that the effect of quant funds is to exaggerate stock market and individual equity moves (e.g., consider the wide daily price swings and knee-jerk action over the last month), those with patience and good timing can be rewarded.

But many will be “scared out of” positions.

My advice?

Kill the quants!

Before they kill some of us!