Man Vs. Machine: The Algorithms
Behind the swift market slide of late 2018 a reality became more noticed. It is that roughly 85% of investment trading volume is on autopilot – controlled by machines, models, or passive investing formulas, creating an unprecedented trading herd that moves in unison and is blazing fast. This is similar to observing a school of fish; their main priority is to swim in the same direction as each other. Algorithmic (algo) trading doesn’t necessarily take into consideration, price, risk, or direction. It’s based on a selected variable(s) and movement(s), up or down – not necessarily valuation. It could simply be a tweet or a breaking news headline that gets the algos buying or selling the market.
Algos are constructed independently of each other, but tend to feed on each other in one direction. Predicting the length and magnitude of the market movement can be as maddening as predicting the movements of schooling fish. Chasing algo trading is not a good proposition for most investors.
At the beginning of 2019 investors were faced with many obstacles including:
- A restrictive Federal Reserve (Fed) policy
- Fears of a recession
- Trade tariff concerns with Mexico, Canada, and especially China
- A lowering of forecasted global economic growth by the IMF (International Monetary Fund)
Investors who participated in the 2019 stock market did well as the algos helped drive the market higher, despite a slowing in US economic growth. Another indicator that algos may have helped push the market higher is the fact that the SPDR S&P 500 ETF Trust (SPY)–the best-recognized and oldest ETF–experienced negative net flows (selling) of $2 billion in 2019, as quoted by ETF.com.
Our prediction for 2019 was that an economic foundation for growth was present and the market could move higher, but we did not predict such an advancement in the stock market.
In the fourth quarter of 2019 the NASDAQ and S&P 500 gained 12.2% and 8.5%, respectively, while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 2.0%. For the year, the NASDAQ, S&P 500, and iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 35.2%, 28.9%, and 5.8%, respectively.
For 2020 the foundation for further economic growth remains intact and further stock market gains are possible. With that said it may be like being on a wild roller coaster, so be prepared to buckle up for the ride. As I see it today, in 2019 money continued to flow to the largest favored stocks which became more expensive while, to a lesser degree, the rest of the market rose on their coattails.
In the below graph the dark green line shows the historical relative value relationship between small and large stocks compared to their average. Note that as of 12/31/19, the last time small stocks were this cheap in relationship to large stocks was 2001 and their most recent peak was in 2008. If history is a guide, there is more reward potential for the small stocks as relative valuations revert back to the average (mean) or their previous high.
Also, in relative value terms, there may be an allocation shift from the US markets to other country markets.
For 2020, here is a short list of positives and negatives facing us at this time:
Positives:
- The Conference Board forecasts economic growth to stabilize around 2 percent in 2020
- The Fed continues a non-restrictive monetary policy
- Progress on global trade continues with China and the US/Mexico/Canada Trade Agreement
- Clarity surrounding Brexit will materialize allowing business leaders to execute their plans
Negatives:
- Investor confidence is too high
- Execution of the Phase One China deal or progress of Phase Two, the more difficult discussion addressing China’s longstanding practice of forced technology transfer, falls short of expectations
- Unexpected outcomes develop during the Federal Election process and election
- Further Iranian retaliation occurs for the US killing of Iranian Major General Qassem Soleimani
- An unexpected presidential Impeachment outcome
- Speculation of a recession begins to materialize late in the year
2020 should be a news filled year with more volatility as geopolitical concerns are elevated and we head through our elections. During the year I expect there will be sector rotation and despite the volatility, the stock market as a whole will produce gains, but not as much as the 2019 stock market gains due to its already high level. In addition, I predict that there will be no recession and no material change in interest rates.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
Very truly yours,
Martin L. Yokosawa