The Quants Are Starting To Cause Trouble

This blog post originally appeared on RealMoney Silver on May 4 at 7:39 a.m. EDT.

Large daily market moves have become almost random events, as increasingly (to paraphrase the Oracle of Omaha), Mr. Market appears to be more of a momentum-based voting machine than a fundamentally based weighing machine these days. The S&P 500 dropped by 28 points last Tuesday, climbed 16 points last Thursday, declined 20 points on Friday and rose 15 points yesterday. How do we explain these sharp moves in either direction? Determining daily share price causality is always a slippery slope. While there are legitimate issues to address later in the year, the current pattern of economic data seems consistently better, and investor sentiment remains upbeat, so there shouldn't be much indecision in economic quarters that would contribute to such uneven daily price movements. Plus, the Goldman Sachs (GS) suit seems relatively isolated and, for now, company-specific, so events in that case should not be a meaningful contributor to the moves either. One possible explanation for some portion of the recent large and random moves is the proliferation of momentum-based, high-frequency trading accounts and hedge funds. While the role of the traditional stock investor is to assess the net present value of a corporation's earnings and share price, many 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 momentum-based approach, which is generally auto-correlated, tries to find repeating patterns and generally 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, most quant funds attempted to be long value and short mis-value -- some still do -- but over time, many of their computer models changed into momentum-based programs, the purpose of which is 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 a lot of the marginal cash flow into hedge funds over the past several years. As such (and given their high-volume methodology), an increasingly large percentage of the trading on the NYSE is quant-program-related; by some measures, these strategies account for between 50% and 70% of daily trading volume.   Loading Comments...   1 2 Last » Next ›

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