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Stock Market Drop Magnified by Computerized Trading

| February 28, 2020
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Comuterized Trading May Have Fed both Last Years Calm, and the Present Chaos

Yes I know this is my third post this week...but it has been a crazy week for investors, so a lot to talk and think about. 

Anyone who pays attention to markets may have noticed that over the past decade, markets have behaved differently.  We seem to have long periods of calm, followed by short but extremely intense selloffs.  In 2015 stock markets fell by over 10% in just a couple of days.  In Feb 2018, the same thing happened.  Then in late 2018, stocks fell almost 20% in a few weeks, followed by a very strong year in 2019.  This week, we have seen an even more dramatic and rapid decline in stocks, with indices pushing close to a 20% bear market drop after being at record highs just last week! 

Of course, this time the fear is fear of the unknown.  No one can really predict the economic fallout from the coronavirus situation.  With such a fast moving and uncertain situation, we would certainly expect that stocks would pay the price, especially as high as they had risen last year.  But once again, it appears that computerized trading is making these movements even more intense. 

The Wall Street Journal yesterday published an article explaining how institutional investors (hedge funds, mutual funds, pensions, etc.) have increased use of programmed trading based on measures of volatility.  That means that when volatility is low (i.e. markets are calm and complacent) these programs buy stocks, which results in a positive feedback loop, making volatility even lower, which fuels more buying, and so on.  The problem is that when things move into reverse, as they did last week, volatility can rise with a vengeance, which fuels more selling, which causes more volatility, which causes more selling, etc.  The slope down becomes far steeper than the slope up. 

In all previous cases when this phenomenon has exhibited itself, the long term investor suffered little or no consequence.  Sure, it was painful to watch the situation unfold, but at the end of the day all the excesses were quickly wrung out of the system things went back to business as usual.  In the past that has resulted in rather quick and rapid recoveries for those who just rode the wave and stayed put in their investments. 

This time may be a little different, because the underlying cause of the downturn is a more tangible and real threat.  In other words, I don’t expect the same kind of rapid snap back from this selloff that we experienced in the previously mentioned “volatility events” because the fundamental economic threat that initiated the downturn is still there.  Still, even here it seems that program trading in the short term is making a bad situation worse and giving all of us who manage other people’s money real angina.  

Solution?  None, really.  Program trading is not going to go away.  But I always figure that awareness and understanding of what is going on can make it a little easier to ride things out, and can help investors tune out the useless noise. 

 

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