I was recently informed by the owner of an artificial intelligence fund that markets do not listen to economists anymore. Rather than immediately dust off my CV and see what transferable skills I might have, I dug around for evidence of his claim and found there was something to it.
A fundamental shift in market structure towards rules-based, passive investing over the past decade means a lot of trading is no longer based on fundamentals. But just because some markets do not pay attention to economists, it does not mean economists should not pay attention to these markets. On the contrary — this shift in market structure could well be a trigger for the next global downturn. The US Federal Reserve is concerned enough that “Changing Market Structure and Implications for Monetary Policy” is the topic for this year’s economic symposium in Jackson Hole.
JPMorgan notes that only about 10 percent of US equity investment is now done by traditional, discretionary traders. AI quant funds use powerful supercomputers to crunch huge amounts of data, unearth patterns and survey trading strategies across different markets in real time. They do not care why markets move, only that they do.
These funds are not waiting on tenterhooks for my analysis of every non-farm payrolls report, Fed press conference, Donald Trump tweet, or earnings report. Instead, they look for trading strategies that are succeeding and adopt those strategies until a better one comes along, regardless of the underlying fundamentals. But what happens when the strategy suddenly becomes to sell everything? Will the computers find the buyers they need?
Passive investments, such as exchange traded funds (ETFs) and index funds, similarly ignore fundamentals. Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher.
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Passive investors and quant funds could also threaten the economy by making markets vastly more complex, noisy and opaque. They send mixed signals to active investors about what the fair value of a stock is. That could cause a significant misallocation of capital.
The danger is exacerbated by the speed at which trading is now done. The average holding period for a security on the New York Stock Exchange has fallen from two months in 2008 to just under 20 seconds today, according to analysis from Cumberland Advisors. Market regulators have put circuit breakers in place, but the flash crashes we have seen suggest they may not work in a crisis.
Systemic failures, misallocation of capital and dried up liquidity could cause a bear market, dragging on growth when the economic backdrop is already lackluster. Do not be fooled by the 4.1 percent growth in gross domestic product in the second quarter of 2018. The underlying fundamentals of the US economy leave a lot to be desired. A market crash — worsened by systemic effects — would probably send the economy into a tailspin.
So even though passive investors ignore economists, economists should pay attention to risks posed by the shift in market structure they represent. One would be hard pressed to find a customer willing to hand their money to an investor who genuinely does not care about fundamentals or price. Yet this is the strategy pursued by passive and quant funds.
This is not to say these funds are necessarily bad. But the real test will come when there is a sudden crisis followed by a sustained bear market. If markets stay liquid, my AI friend might be right. If not, I will be waiting by the phone to discuss the fundamentals that might lead to recovery.
Interesting take … Let me know what you think.
