Algorithms, Derivatives and Manias: A Day of Reckoning?

04/11/2019 5:00 am EST


Alan Newman

Founder, Crosscurrents Publications, LLC

Stocks bottomed in March 2009. From April 2009 through the end of 2018, more than $878 billion flowed out of equity mutual funds, $778 in just the last four years, observes market timing specialist Alan Newman, editor of CrossCurrents.

The only years in which funds saw net inflows were 2013 and 2014. Stocks gained 36% in those two years but also gained close to 31% in the last four years with gigantic outflows.

How is this even possible? For several years, we railed against indexing, such as the S&P 500 ETF (SPY) created to mirror the S&P 500, an index weighted by capitalization.

Pharmaceutical giant Eli Lilly (LLY) is larger than Netflix (NFLX) in terms of revenue, profit and number of employees but the latter is more heavily weighted, thus for any new money invested in the SPY, a larger portion of NFLX will be bought than of LLY.

This factor results in higher prices for NFLX, simply because the company’s capitalization is higher than LLY. The transactions have nothing to do with value. This skew creates a situation akin to a feedback loop.

The skew has existed for decades and continues to exacerbate the second worst valuation gap in stock market history.

Worse yet, algorithmic trading continues to proliferate and accounts for even more transactional dollars and volume. It is estimated that as much as 80% of all trading is now governed by rote, mechanically, automatically, and without human decisions.

When the tech mania peaked on March 9, 2000, it was estimated that only 15% of trading was mechanical. The annualized share of human volume was then roughly $17.9 trillion versus $3.2 trillion in trading governed by algorithms. Total dollar trading volume has grown tremendously since then and is up more than four-fold.

Last year, trading governed by humans amounted to the very same $17.9 trillion. Algorithmic trading amounted to $71.5 trillion, accounting for the entire increase in total dollar trading volume from the peak in March 2000 through the end of 2018.

Derivatives for the top 25 commercial banks now total $176 trillion and the net assets of the entire group are only $11 trillion. Wherever we look, we see risk on possibly the greatest scale ever.

As in 2000 and 2007, prices have gone far beyond what reason would ascertain. The ten year bull market is now the longest in history but it will not last forever. Like the two preceding manias, there will be a reckoning.

We’re not just dealing with the possibility of a bear market. We’re dealing with the possibility of the major averages eventually losing as much as 45%-50%.

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