Can Algorithms Really Take Over the World of Investing?

06/30/2017 2:53 am EST

Focus: STOCKS

Joan Lappin CFA

Chairman and CIO, Gramercy Capital Mgmt. Corp.

Algorithms might change but human nature does not. We all love instant action. The only problem is when the music stops and fund managers, human or robots, are all crowded into the same handful of trades, asserts Joan E. Lappin founder of Gramercy Capital Management in 1986.

Long ago and far away when I began my Wall Street career the most prominent ad for a mutual fund company showed a Dreyfus lion growling as he emerged from the Wall Street subway stop in the IRT. At the same time, the NYSE was then promoting investing as the idea to "Own Your Own Share of American Business."

That seems quaint today when as much as 90% of daily trading is generated by computers. Some of those trades last for just seconds. In and out to garner fractions of a point. Once computers facilitated trading large blocks for tiny commissions, the little guy was pushed to the dust bin.

Now it is college grads with PhDs in math and physics who are writing formulas to determine what should be bought or sold and the precise moment when the trade should be executed. Economics isn't the desired major anymore. What is actually going on at the subject company is receding into the background as even relevant to the decision to buy or sell.

While companies mostly don't tweet at 5:45 a.m. as our restless POTUS does, events at the subject company are just an excuse for a rush to buy or a race to exit. The Talking Heads on TV financial shows are asked to perform instant analysis the moment a company releases its quarterly earnings.

Pity the poor person appearing recently on CNBC to discuss his favorite buy idea. He chose to talk about Restoration Hardware. The company beat estimates and the numbers on their surface looked good. He thought it was a great idea. However, the poor fellow became an instant idiot when as he was talking the stock plunged about 20%. What is there to say after something like that happens to you? One supposes it makes you think a few times before accepting another invitation to appear on TV. Usually, about 12 people an hour are paraded across the set of the financial talk shows. Even if you are on, you are lost in the shuffle of who is marching across that hour. Your PR person must call them to get you back into the queue.

In June the Wall Street Journal ran a most interesting story about the poor 2017 performance of so-called "Quant" funds managed solely by algorithms. As we near mid-year, this category is trailing even hedge funds which are also flailing. Money is gushing toward the Quants right now despite the fact that they are doing the worst. Why is that? Money always chases what last worked best even after the tide is rushing out on that style.

Calculations seem to show that about 40% of the gains in the major averages this year are accounted for by the FANGs: Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google now Alphabet (GOOGL) plus Apple (AAPL) and Microsoft (MSFT). The latter two sell at normal price earnings multiples. The others sell at very high multiples of little or no earnings. So about six stocks are driving the bus out of hundreds. The others are not doing much.

It seems that the algorithms have been designed by humans to do exactly what humans do, only faster. That is, Quants love to follow the spot on the tail of the dalmatian ahead of them toward momentum stocks that are moving higher day by day. Amazon is now beloved. But remember that despite selling for $1000 a share, Amazon has been public for 20 years now. That is 80 quarters. AMZN has made money in about 8 of them. It earns little when it does earn anything. Yet right now, nobody cares.

Algorithms might change but human nature does not. We all chase a quick buck. We all love instant action. The only problem is when the music stops and fund managers, human or robots, are all crowded into the same handful of trades. One never knows when it will end. But we all know neither trees nor stocks grow to the sky. The laws of gravity apply to the stock market as well as to us when we are climbing out on a limb. In the end, it isn't a question of if. Only a question of when the end comes for the momentum crowd.

View more from Joan E. Lappin and Gramercy Capital Management Corp. here

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