That was a brutal start to May!

This week, we look at two factors which drove market behavior last week: the vastly increased speed of trading and the emotional transmission mechanism.

The speed of trading

For several hundred years, the laws of physics pioneered by Sir Issac Newton were the foundation of the industrial revolution. By measuring, understanding and harnessing the natural forces all around us, inventors, entrepreneurs and others were able to build machines, power plants, factories and all the modern conveniences that we take for granted today. However, as we started to explore the very small (atomic scale) or the very fast (speed of light) or the very massive (the universe), Newtonian physics broke down. It failed to explain our observations. As a result, Albert Einstein was compelled to invent a new set of laws. Those laws did not invalidate Newtonian physics (an apple falling out of a tree can still hit you on the head) but it recognized the old physics as a set of rules that work when things aren’t moving extremely quickly or are extremely small or large.

Moving over to the financial markets, we are in the same place as Einstein and others found themselves in the early 20th century.

The Efficient Markets Hypothesis and Modern Portfolio Theory were crafted in the middle of the 20th century when the speed of financial markets were within normal human scale. Transactions were initiated and executed by humans using telephones, scraps of paper, pens, order books, haggling and time stamp machines. In physics, it was still about the apple rather than the subatomic particles which make up the apple.

But, now speed forces us to reevaluate our understanding of the financial markets. According to an article in the FT, transactions can now take place in as little as 16 microseconds. To understand how fast that is, note that the average human eye blink takes 350,000 microseconds (ref). So, we have entered the age of Algorithmic Trading in general and we are seeing how one cutting edge product, which has been christened “High Frequency Trading” (HFT), has changed the nature of the market.

HFT is estimated to account for 50%-70% of the daily volume in US equities. It is a heady period not dissimilar to the excitement that surrounded the dawn of the atomic age. Scientists in a number of countries raced to turn the new physics theories into real world applications in the 1930’s and 1940’s. Success in the atomic race translated into superpower status in the post-WWII period. Success in HFT has already translated into outsized profits at firms like Goldman Sachs.

And just as regulation did little to stop the proliferation of nuclear technology, one should not expect too much to come from efforts to control this latest advance in the science of trading financial assets. The SEC has tried to curtail “flash trading” but it will be difficult to convince market participants to not seek ways to profit from their high speed machines.

Unfortunately, just like early experiments in harnessing the power of the atom, occasionally the chain reaction process gets out of control. Last Thursday, the computers got stuck in a loop, cratering the market before anyone could hit the “reboot” switch.

The emotional factor

So, how does a computer loop translate into a global phenomenon? In our interconnected world, assets are constantly being measured against one another. The ability to move from emerging market equities to short term US Treasuries or Gold is almost frictionless for a medium sized institution. All the excess cash created by our Central Banks is sloshing around the financial markets chasing returns. So, when Institutional investors smelled smoke, they had to assume that there was a fire nearby. Given the speed issues explored above, a “shoot first, ask questions later” attitude has emerged. In short, traders pushed the panic button. In the US, they pulled their bids and let the computers find out just how low they could go. In the rest of the world, they dumped “beta” and dove for safety.

That’s it?!?! There must be more behind the story than that! Part of the emotional component of the markets is our need for an explanation that we can grasp; we need a scapegoat. We must have a cause and effect in order to feel that we have control over the universe or at least our corner of it. So, where was the fire? Was it Greece, which has been exposed as a financial basket case for months now? Was it the Euro, which is showing the strain of the substantial political compromises that accompanied its creation just over 10 years ago? Was it the UK elections where observers have been calling for a hung parliament since the beginning of March? Was it a “fat finger error” where a junior clerk sent an order for billions instead of millions? One thing is for sure: this story is too good for the media and congress to ignore. But as investors, we should not spend much time with these historic events that were well discounted. The markets look forward and so should we.

How to deal with high speed markets

Although the price of computing power has come down through the decades, the systems that drive HFT are still well beyond most investors’ budgets. And, even if we had access to those systems, success is not assured. As we saw on Thursday, even the traders whose job it is to watch the markets on a tick by tick basis were powerless in the face of a rogue wave of computer generated trades. Developing a system that works in increments of 10s of microseconds is not a viable option.

Since we have been comparing the new market to modern physics, perhaps we should take a page from the physicists’ handbook at the atom smashers in the US and Europe. Contrary to popular imagination, the scientists as CERN do not throw the switch and see what comes out the other end (maybe a black hole!). They spend years planning for their experiments so that when the near light-speed collisions occur, they already know what to look for. Once the protons start ramping up to 7 trillion electronvolts, there are no technicians scrambling around the tunnels with socket wrenches.

Investing should be the same. One should have an investment plan and universe of assets firmly in mind before investing in the financial markets. If your goal is to fund retirement in 10 or 20 years, days like last Thursday are non-events. Using a systematic approach that allows you to regularly review and rebalance your portfolio will allow you to keep well positioned for whatever the market decides to throw at us.

One of the tools which helps one to maintain a longer term perspective is the Weekly Leading Indicators from ECRI. The ECRI is founded on the study of the Business Cycle which has managed to survive many announcements of its demise. As you can see from the chart, we are still expanding. There is no doubt that we will hit corrections along the way but until the WLI turns negative, the chances of a double dip recession are limited.

ECRI's Weekly Leading Indicator

But what about the impending collapse of Europe?

The problems in Europe are significant as the internal contradictions of the Euro come sharply to the surface. But two things are likely to happen. First, Germany and France are going to find ways to bail out their banks. If that means saving Greece and Portugal at the same time, then that is what will happen. Second, a weakened Euro will help export related companies in the core industrial center of Europe (Germany, France, Northern Italy…). Although European leaders will denounce “market speculators” a 10% shift in the value of the Euro vs. the Dollar will have a significant impact on exports in the coming months. A bigger shift will have a proportionally bigger impact. So, while one might shy away from Greek sovereign bonds in the coming few weeks, there should be significant opportunities for the former Eastern European countries that supply the German export machine. That is why you will find Emerging Europe on top of the System Rankings and near the top in many of the portfolios.

Other Picks

In our international mutual fund portfolios, Japan and India still rank highly although EPI, the Indian ETF does not make it into the top rankings of our ETF portfolios. US Small Caps, High Yield, Real Estate Related, Biotech, Technology and even Financial Services feature in the top rankings as well.

Filed under: Developed MarketsMarket CommentUS

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