This week’s stock market drop was machine-made. The freakout that followed was man-made.

It's vital to distinguish between real-world economic conditions and changes in the way markets function.

FROM THE WASHINGTON POST | FEBRUARY 7, 2018

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“Dow plunges 391 points as fear grips markets.” A headline from two days ago?

Try two years ago.

Jan. 15, 2016, to be precise. The last time stocks exhibited the sharp sell-off — followed by an equally sharp run-up — that characterized the past few days. Monday, the Dow Jones industrial average was down about 1,600 points, the largest intraday point-drop ever, before ending the day down a mere 1,175 points, or 4.6 percent. Those numbers drew maximum attention from cable news outlets, which had run stock tickers and market updates in the lower thirds of screens consistently in the years after the market chaos of 2008-2009 but had done so only intermittently in recent years.

But while the absolute number was impressive, the market rout barely cracked the top 100 in percentage terms. Tuesday’s subsequent rally, which saw another thousand-point swing, was equally dramatic, happened in the space of a few hours and reflected a reality obscured by all the hand-wringing and teeth-gnashing: What happened this week was mostly caused not by people but machines.

Headlines over the past few days mirror those from not only January 2016 but also August 2013May 2011, the infamous “Flash Crash” of 2010 and the more severe drop that accelerated in late September and early October 2008 at the start of the financial meltdown. And those are examples from the past decade only — go back to the late 1990s and through the 2002 market collapse and you will find much the same.

Not only are reactions to these dips predictable, so are the dips and surges themselves. This most recent round of volatility has been among the most expected in recent memory (except, perhaps, by President Trump, who Wednesday offered, via Twitter, a sophomoric good-news/bad-news analysis that amounts to markets making a “big mistake”). Analysts, investors and financial commentators have cautioned for many months that markets have been long due for both a correction and a return to volatility. Reacting to the possibility that central banks would begin tightening monetary policy, last year the Telegraph quoted Bank of America Merrill Lynch investment strategist James Barty saying: “Markets do not like the sound of this.”

Traders measure market volatility in a variety of ways, but one of the most common, and agreed upon, is an index known as the VIX, which for the last few years has registered low volatility. The absence of volatility, though, can indicate complacency, and since the downgrade of the United States’ sovereign debt in 2011, the threat of downgrade in 2013 and the 16-day 2013 government shutdown and a few weeks of selling in 2016, markets have been relatively calm. As a result, the question for most involved in financial markets has not been whether that calm would continue, but when it would end, and it finally did.

It’s easier to be sanguine about volatility when markets are calm and rising than when the storm hits. And as many were quick to note, the sell-off wasn’t triggered by any sudden change in national or global economic fundamentals, and in fact, occurred in the face of a strengthening U.S. and global economic backdrop. The evidence in last Friday’s jobs report, that wages are up 2.9 percent, appears to have been a triggering factor, insofar as it pushed “speculation” that the combination of a heated economy, modest inflation and recent tax cuts would soon force the Federal Reserve to raise its interest rate target more quickly, which in turn might end the party just as it is getting started.

The fast fall and speedy rebound, therefore, is a market-generated phenomenon. That doesn’t mean there’s no cause for concern, but concern should be about the changing nature of investing rather than anxiety that what is happening says something about the real-world economic forces shaping most people’s daily lives.

 

The real issue for markets is how technology and automated, program-driven trading can and is creating powerful anomalies in how markets work. Markets have roiled before, but the way they plunged and then recovered in the past few days can only be explained by software and passive trading that lead to blind selling and blind buying. At one point Monday afternoon, shares of a company such as Boeing traded down nearly 10 percent in a few minutes. But as Steve Grasso, a CNBC analyst and longtime trader explained, “There is never a time when a human being is going to sell a stock down that much in a matter of minutes. People don’t liquidate stocks like that; machines do. And then people react and start to mimic.” On the flip side, almost no one pushes the buy button as quickly or aggressively as algorithms.

JPMorgan recently estimated that only 10 percent of stocks are now traded daily by individuals making active choices about what to buy or sell. That figure may be low, but we do know that a large portion of all stocks are owned in relatively new investment vehicles called Exchange-Traded Funds (ETFs) that represent a passive basket of stocks, and that a number of hedge funds are composed of tens of billions of dollars investing not just in those ETFs, but in derivatives (instruments such as options or futures) that are structured to generate double or triple the returns of those ETFs, or the inverse. Most days, all those baskets and derivatives cancel each other out. But they sit there waiting for days when activity accelerates, pegged to programs that buy and sell based on how quickly prices are moving. The result is a market that is often placid but can take a slight wind and turn it into a selling vortex and then reverse direction and become a buying hurricane.

That’s what happened in the past few days. Fueled by technology, these moves are often so rapid that it is almost impossible to protect oneself or profit from them without an algorithm. For now, it appears that the storm has passed, but there are surely more to appear on the horizon.

It used to be that it made sense to connect dramatic market moves with real-world economic fundamentals. That might still be true in the most basic sense. After all, equity markets have been rising these past years against a backdrop of a good U.S. economy and an okay global economy, with companies benefiting from any gains much more than most individuals. But, given the rise of the machines, the tendency to react when markets go nuts for several days and to find a story that speaks to the real world is probably a serious mistake, unless there clearly is a real-world reason, such as a sudden geopolitical crisis or an accumulation of economic data that says the winds are shifting.

The still opaque but increasingly dominant role of machines and passive-trading vehicles, however, needs attention — from financial institutions, from regulators and even politicians. Real world or not, markets are made up of tens of trillions of dollars of people’s savings, of pension plans and endowments, of national assets and personal ones. Average investors might be tempted to make decisions about their 401(k)s (and certain presidents might be tempted to make “braggadocious” claims about their robustness) based on breathless financial news. Add in the hyperbolic nature of headline writing and a general tendency to forget the last time this happened, and it becomes vital to distinguish between market freakouts and the real world.

Source: https://www.washingtonpost.com/news/postev...