Rage Against the Machines: Algorithms Losing Steam

I read a great blog on Bloomberg this morning that talked about “fundamentals” versus “technicals.”

For those who might not be aware, “fundamental” metrics attempt to measure the actual value of a stock. For instance, how much revenue a company might generate, or what operating costs will be.

“Technicals” on the other hand, are only concerned with a stock’s price and volume… nothing else.

But the question of which one should be used first inevitably comes up in every job interview.

The truth is that they’re both correct, but which one you prioritize depends on your job – or in the case of retail investors, your goals.

If you’re a strategist (like I’ve mostly been in my career), then a good answer would be: “I form a fundamental view and then use technicals to select entry and exit levels.”

But if you’re a trader, the pace of your job means that you don’t have the luxury of contemplating your long-term view… you’re too focused on the here and now.

Now, I spent the bulk of the last couple of years building data tools to evaluate technical trading strategies, and I learned a lot in the process.

Mostly, what I learned was that the bulk of those strategies are actually viable, but you have to know how to use them – most perform better under specific market conditions.

And for your average everyday human person, monitoring those can be impossible.

Enter algorithms.

Simply put, an algorithm is a computer program that follows a set of instructions to place a trade automatically – it takes the human element completely out of the execution altogether.

This kind of trading began on a relatively small scale in the late 1980’s and early 1990’s at firms like D.E. Shaw & Co. and Jim Simons’ Renaissance Technologies.

But with the onset of passive investing funds in recent years, it has come to represent as much as 80% of daily volume.

What that has come to mean for strategists like myself is that since most volume is algorithm-oriented, any change in volume above normal means that something is changing.

You can see it when we look at the last five years of the S&P 500, for instance, depicted in the chart below.

Source: Bloomberg

In each case here, the rise in volume were humans piling into the market to sell their stocks.

The other thing you should notice in that chart is that before each of these pullbacks, stocks were rising effortlessly on very little volume.

But whenever those runs stalled out, it was an indicator that the market was about to turn.

So now let’s take a look at the last month.

Source: Bloomberg

Here, we can see that the vast majority of trading occurs in the last 15 minutes of the day – this is almost all algorithmic trading.

We can also see that when end of day volumes spike above normal levels, it precedes a downturn in the next session of two.

And lastly, we can also see that those spikes are preceded by lower-than normal volumes where the rallies run out of steam.

That’s especially true on a longer-term basis, where it sure looks like markets are setting up for another leg downward.

Source: Bloomberg

End-of-day volumes seem to be losing steam… and upside appears limited.

Now, I’m not exactly sure what’s going to cause the next lurch downward, but I know I want to be in position to rage against these machines…

The following actions should do the trick:

Add another ¼ stake in Velocityshares 3x Long Gold ETN (NASDAQ: UGLD).

Add another ¼ stake in Direxion’s Daily MSCI Emerging Markets Bear 3X Shares ETF (NYSEArca: EDZ).

Add another ¼ stake in ProShares UltraShort Euro ETF (NYSEArca: EUO).

Pick up a new ¼ stake in ProShares UltraShort Bloomberg Crude Oil (NYSEArca: SCO).

If we don’t get a pullback soon, these are still very attractive prices for these stocks.

But if the market does lurch lower… each one of those should show significant upside from here.

All the best,


Matt Warder 


This article is supplied courtesy of WealthPress.com


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