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Robo-Traders: Stocks Soar as Algorithms Fuel Volatility

John Connor: “You don’t feel any emotion about it one way or another?”

The Terminator: “No. I have to stay functional until my mission is complete. Then it doesn’t matter.”

The dialogue comes from the 2003 movie Terminator 3: Rise of the Machines. But that verbal exchange could have come from the trading desk of any large asset manager. As I explain below, machine trading has conquered Wall Street.

The major indices soared Monday, after two weeks of extreme volatility. Shunted aside were fears of higher interest rates and inflation. For now.

Investors turned their attention Monday to President Trump’s $1.5 trillion infrastructure plan. In many ways, though, the plan is really an expensive privatization plan. Left unsaid was where the money would come from, in the wake of a $1.5 trillion tax cut that explodes the federal deficit.

Also in the spotlight Monday was Trump’s proposed $4 trillion budget for next year. The 2019 budget would double the federal deficit to $1 trillion.

Self-proclaimed fiscal hawks suddenly don’t seem to care about deficits. Perhaps they never did and their only concern was policy outcome, not fiscal prudence.

Regardless, Wall Street is being short sighted. Investors still haven’t grasped the dangerous, long-term implications of these vast deficits. With the complicity of Democrats, the ruling GOP has abandoned its oft-professed budgetary discipline. Stimulus is being applied during a recovery, which could overheat the economy.

When the next recession hits, policymakers will have fewer tools at their disposal. We’re witnessing a big economic gamble.

Bond yields have been rising; deficits will push them higher. The yield of the benchmark 10-year Treasury note has spiked from 2.4% on December 29 to 2.86% as of today. Momentum stocks are vulnerable in this rising-rate environment, especially large-cap tech firms with overly optimistic earnings projections.

Machine-made gains and losses…

Stocks skyrocketed on Monday. But from their high point on January 26, stocks have fallen about 10% (even if you factor in today’s nearly 2% gain). That’s correction territory.

Fueling this volatility is program trading. Individual investors who want to profit from the markets but don’t see themselves as stock-picking wizards are opting instead for exchange-traded funds (ETFs) and index funds. These vehicles are managed via software algorithms. Hence the term “passive investing.”

ETFs that track financial indexes have become a major factor for the recent roller-coaster action in stocks. These funds act as accelerants, up or down. They could make the next crash worse.

There’s been a proliferation of passive funds that track indices cheaply and others, called “smart beta” investments, that mimic elements of what humans do at far less cost.

Index funds and ETFs charge annual fees that are only a small fraction of what an actively traded fund charges. The latter need highly paid “talent” to conduct research and conceive strategy.

Since 2000, investors have removed $2.5 trillion from active funds and plowed roughly the same amount into passive ones. About two-fifths of the global industry’s equity assets are managed passively, up from nearly zero in 2000, according to research firm Sanford C. Bernstein.

The popularity of passive funds has concentrated financial clout into the hands of BlackRock (NYSE: BLK) and Vanguard. They’re the two biggest providers of ETFs and index funds. Combined, they hold $10.5 trillion in assets and control 65% of the 1,700 ETFs in existence.

Average investors gnash their teeth during huge market swings. The folks at BlackRock and Vanguard impassively gaze at computer screens. There are no portfolio managers yelling market orders. Software programs are doing the work. No human emotions are involved. Machines are in charge.

This transition on Wall Street from human to machine has been unfolding for many years, but the repercussions are now starkly apparent. These past two weeks, as markets whipsawed investors, ETFs were responsible for about 40% of total stock trading on some days.

It’s easier to make money with passive funds during a bull market. The true test comes at low tide during a market crash. That’s when investors face a strong temptation to sell, which is usually a mistake. It’s during times of turmoil that the active approach can make a big difference.

There are proactive measures that not only protect your portfolio but also retain a growth trajectory. I’ve examined those measures in recent issues of Mind Over Markets.

My two takeaways for today: Don’t put your portfolio on automatic pilot. And don’t think this correction is over.

Monday Market Wrap

  • DJIA: +1.70% or +410.37 points to close at 24,601.27
  • S&P 500: +1.39% or +36.45 points to close at 2,656.00
  • Nasdaq: +1.56% or +107.47 points to close at 6,981.96

Monday’s Big Gainers

  • CSRA (NYSE: CSRA) +31.12%

Federal IT firm targeted for acquisition by General Dynamics (NYSE: GD).

  • Amber Road (NYSE: AMBR) +23.37%

Global trade management firm eyed for merger.

  • Apple (NSDQ: AAPL) +4.03%

Tech bellwether bounces back after sell-off.

Monday’s Big Decliners

  • NL Industries (NYSE: NL) -10.10%

Basic materials maker faces flagging demand.

  • Lumber Liquidators (NYSE: LL) -8.86%

Bearish forecasts weigh on lumber retailer.

  • Semiconductor Manufacturing International (NYSE: SMI) -8.15%

Analyst downgrades chipmaker.

Letters to the Editor

“What’s the difference between an ETF and an index fund?” — Donald C.

Typically, index funds are cheaper. They’re un-managed funds that change their individual holdings only when the underlying index changes.

Unlike an index fund, ETFs trade on exchanges in the same manner as a stock. That means ETFs provide more flexibility than index funds. However, index funds don’t incur commissions and have lower internal expense ratios.

Because ETFs trade on the market, you can execute with an ETF the same types of trades that you can with a stock (unlike an index fund). For example, you can sell short or impose a stop-loss order. In this sense, it’s less passive than an index fund.

Got questions about ETFs and index funds? Drop me a line: mailbag@investingdaily.com

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.

 

 


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