Daily State of the Markets, Market Analysis, Market Commentary

Why Tactical Isn’t Working – Part VI (The Rise of the Machines)

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One down, one to go. Important central bank meetings, that is. While we will have to wait a few more hours to hear whether Janet Yellen’s merry band of central bankers is going to raise interest rates today, we did learn overnight that the Bank of Japan will now target the level of interest rates with its monetary policy (apparently the goal will be a 0% yield on the Japanese 10-year) instead of trying to expand the money supply. The news from the BoJ was treated kindly by traders as stock and bond prices in Japan rallied strongly on the news.

The upbeat mood from the overseas markets has spilled over to a degree here at home, but traders aren’t likely to make any big moves until Ms. Yellen steps to the microphone this afternoon. As such, let’s continue the discussion on why tactical/technical strategies have not fared well in recent years.

Yesterday, we established that both tactical funds and hedge funds both have experienced significant underperformance relative to the S&P 500 since 2008 – and especially since 2011. The key question, of course, is why is this happening?

In this series, I have been saying that I see three primary reasons for the struggles in tactical trading arena: “Everybody’s doin’ it,” “Global QE,” and “The rise of the machines.”

Let’s Talk About the Computers

For years now, I have been suggesting that the character of the way the markets trade on a daily basis has changed due to the proliferation of algorithmic trading strategies on the exchanges. It started with computers “mining” the headlines for key words and automatically trading on them at the speed of light. From there, programmers worked with traders to code up just about every trading strategy known to man.

The key is that today’s stock market isn’t controlled by the market makers, the institutions, mutual funds, or even the hedgies. No, according to the stats I’ve seen, the vast majority of trading done on the stock exchanges today, which these days are also electronic, is done by computerized algos.

From my seat, this is the reason why volatility spikes have become the norm. This is why the “V-Bottom” has become so prevalent. And this is why so many indicators/models that were once a reliable indication of the stock market’s internal health – as well as a being a good harbinger of things to come – have simply stopped working.

The key here is to understand that the machines don’t care about that trendline that looks so important to you. They aren’t really concerned about the support zones on the charts. And unless we are talking about the all-important 200-day (which is important, because, well, just because), the algos don’t give a hoot if a moving average or trading band is violated – in either direction.

No, the computers simply execute their trading strategies over and over again until the end of the day. Thus, when a trend in the markets starts to roll, everybody playing what I call the “Millisecond Trend-Following Game” piles on until the closing bell rings.

While it may be just one man’s opinion, I believe THIS is the reason that intraday volatility has increased so dramatically in the past few years. This also explains why there are so many big reversals in the market from one day to the next. Remember, if you trade on a millisecond basis, you don’t need to concern yourself with the major trend because today is the only time frame that matters.

How Many Milliseconds Are There in a Trading Day?

I keep a sticky note on my desk that reminds me there are 23,400,000 milliseconds in a full trading day. This means that there are 23.4 million data points for your trend-following algos to work with. And if my spreadsheet is correct, this means that the millisecond trading gang has the equivalent of 9.3 years of daily bars available to trade on each and every trading day.

In other words, the algos don’t need to worry about tomorrow, the next week, or the next month. They have PLENTY of price points to work from every single day. The trend of the next 10 minutes is the key here. Again, today’s computers have as many data points to trade on each session as the folks using a daily chart would have over 9.28 YEARS. And from my perch, this would appear to be the reason that high-speed trading now dominates the markets.

So, with so many folks using their fancy algos and their co-located computers to automatically trade at the speed of light, intraday moves have become increasingly exaggerated. While I’m just spitballin’ here, my estimation is that big intraday moves that tend to be driven by news, are now 30% to 50% larger than they once were.

And as a trader, what do you do when a move becomes “overdone” in one direction? Oh that’s right, you go the other way. And yes, fans, this too is programmed into the machines. So, once a move “goes too far” the mean reversion algos kick in and voila, yesterday’s big, bad decline has been reversed!

What Is Real?

The question then becomes, what moves are “real” today? Was the exaggerated decline from yesterday important? Or was the fact that the market put in a spirited rebound today the real takeaway?

The problem is that it has become very difficult to determine what the “real” move in the market actually is. And – again, in my opinion – this is the reason that so many trend and momentum indicators have stopped working. Because, in short, nearly every move can look like an “important move” from a technical standpoint.

This helps explain why tried and true indicators such as “thrust signals” in price or internal momentum (which were once solid buy/sell signals) have become commonplace and as such, much less valuable.

The Bottom Line

So, if you are a tactical manager using traditional indicators/models, chances are pretty good that you’ve been struggling with underperformance lately. And the reason is simple, the traditional signals and models you are using to guide your buy and sell decisions in the market are being consistently fooled by the exaggerated intraday moves caused by “the rise of the machines.”

For example, Ned Davis, a 40-year stock market veteran and founder of Ned Davis Research (and one of my early heroes in the game), recently told his clients, “This is not the stock market I grew up with.” And while one of Ned’s claims to fame is that he has never had a losing year, his key point here is that you have to adapt to the game when it changes.

Which brings us to the next part of this series – what managers and investors using a tactical/technical approach can do about the changes to the market’s character.

Publishing Note: I am traveling the rest of this week and all of the next. Thus, reports will be published as my schedule permits.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Global Central Bank Policies
      2. The State of U.S. Economic Growth
      3. The State of the Bond Market
      4. The State of the U.S. Dollar

Thought For The Day:

It’s difficult to follow your dream. It’s a tragedy not to. — Unknown

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

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Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

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About the Author

David Moenning is the Chief Investment Officer at Sowell Management Services. Dave began his investment career in 1980 and has been an independent money manager since 1987. Thus, Dave has been live on the firing line and investing for a living for more than 29 years.