One unfortunate habit that we commonly see with investors is the tendency to look to short-term market activity for investment guidance. In Behavioral Finance this is referred to as “herding” (or convoy behavior) which is the hardwired instinct of most human beings to flock together for perceived safety. When individuals are not confident in their independent position, they typically acquiesce to the group. Unfortunately this can also be true even when individuals do have confidence in their independence. Accordingly, there is a general understanding in the money management industry that it can be okay to be wrong when your peers are also wrong, but being wrong independently can cost you your job.
Over the past couple of years global stock markets have experienced levels of volatility never before seen in history. Recently the media has started referring to this as “risk-on/risk-off”. Regardless of what you call it, markets have inarguably been exhibiting symptoms, which exhibited in a person, would be diagnosed as manic depressive disorder. And there are some fundamental justifications behind this: High-public and private debt loads, the recessionary pressures of deleveraging, unstable short-term economic prospects....it has all been said a hundred times before. Regardless of the source of the volatility, it has investors at the edge of their seats ready to hit the sell button; frantically looking for any sign that the markets might fall of the proverbial cliff like they did in 2008. Real economics are a force in the recent volatility but there is also another force at play and it has nothing to do with fundamentals. This other force is investors’ own biases (private and professional) and how we make our buying and selling decisions, also known as investment strategy. And it plays a big part in the markets’ current volatility.
You can divide investment strategy (or investment mentality) into four main camps: 1) buy and hold; 2) momentum; 3) value; and 4) pure speculation. Each of these investor types makes buying and selling decisions based on a different set of rules, and the resulting actions impact the market in different ways. The buy and hold investor is the most benign of the camps. They don’t make investment decisions and asset allocation decisions based on overall market conditions. This type of investor passively purchases stocks when they have capital available, and looks to hold his positions through market cycles and varying conditions. Momentum and value investors, on the other hand, are not passive; they actively look for opportunities. Momentum traders will buy into market uptrends and then sell into market declines, without consideration for actual economic or company fundamentals. They are basing decisions purely on volume and price movement. Value investors will take a more contrarian approach, typically buying into market price weakness and selling into market price strength. In contrast to the momentum investor, the value investor will base decisions on fundamentals and not price chart formation. The characteristics of the fourth group, the pure speculators, are less relevant to this discussion but would typically exhibit buying and selling behaviour similar to the momentum camp.
The effect that momentum trader and value investors have on market volatility is polarized. When the market moves in one direction, the momentum traders exacerbate the movement, and therefore increase market volatility, by increased buying when the market is rising and increased selling when the market is falling. In fact, momentum investors unwittingly work together to generate market extremes. But when market prices move too far in either direction, value investors get involved. When prices get too high, value investors create a dampening effect by selling into the strength. Then, momentum investors begin to see the uptrend slowing, and they start to sell. As the market weakness persists, more and more momentum trades drive prices continuously lower until value investors start to see opportunities and move in to create support though increased buying. And so on and so forth, the cycle continues.
It may be apparent that not all investors fit neatly categorized into one of these investment types, because real world investment strategy involves a lot of human behavior and is too complex to be summarized into a few lines of text. Some investors will utilize multiple investment strategies. For example, an investor can purchase on value but then transition to a buy and hold approach. Investors can also purchase on initial momentum but then sell on value. Some investors will subscribe to one strategy in theory but another in practise. Some investors switch between strategies from trade to trade. And in the case of professional money managers, there is also the structural issue of investor contributions and redemptions: the fund manager may subscribe to a value strategy, but if the fund investors decide to redeem in down markets and contribute in up markets, the impact the fund has on the market may be more closely associated with momentum than with value.
Complexities aside, most investors, whether they know it or not, are largely loyal to their respective strategy. Equally true is the growing trend in favour of momentum strategies. This trend, which naturally increases volatility, is due to a number of reasons. The evolution of discount brokerages and low cost trading has made trading easier from a logistical and financial perspective. Many brokerages also encourage excessive trading by offering lower fees to high-frequency traders and platforms which provide momentum-based, technical analysis research tools. Next, a virtual explosion has occurred in the market for computerized trading programs that promise to automate the BUY/SELL decision for retail investors who have limited research skills. These retail trading programs are also based on momentum indicators. Of course, legitimate global economic risks have also reduced investor confidence in long-term stock market returns, and increased investor scrutiny. These factors make investors, on average, more willing to hit the sell button at the first sign of trouble and potentially the buy button when the market appears to be improving. And finally we have the onset of high frequency trading (HRT) companies, which have exploded in numbers and importance over the past several years. HRT uses sophisticated computing programs to execute (in some cases) thousands of trades per minute, resulting in profits of a faction of a cent per trade. The impact of HRT in today’s market is becoming more and more evident. Estimates will vary, but the research we have seen is staggering: in August 2011 (an extremely volatile period) Bloomberg reported that the percentage of average daily volume attributable to high frequency trading had exceeded 80% in the US markets.
We only need look to the Flash Crash of 2010 (also referred to as The Crash of 2:45) for a recent example of how momentum trading creates abnormal volatility. The Flash Crash occurred on May 6, 2010, when the Dow Jones Industrial Average plunged about 1000 points and then quickly recovered after a few minutes. This was the biggest intraday point decline in the Dow’s history. On September 30th, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) issued a report on the crash after a five month investigation. The report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral.” The report also discussed how immediately before the crash, a large institutional investor sold an unusually large number of S&P 500 contracts. The report concluded that this activity put selling pressure on an already weak market, which triggered high-frequency traders to start selling aggressively, causing a mini-crash to occur.
Put into context of the divide between different investor camps, the amplified market volatility we have seen in the past year becomes easier to understand. There has always been a divide between momentum and value investors. The difference today is that technology has facilitated a trend towards momentum trading, which in conjunction with real fundamental risks, has had the effect of amplifying market volatility. Since none of the trends that are facilitating momentum investing show any sign of slowing, it may be perfectly rational to conclude that higher volatility is the new normal, regardless of whether the world finds a solution to its financial woes. While this may be disconcerting for some value investors, it really shouldn’t be: remember, value investors move in to restore rationality when momentum investors distort valuations. When the Flash Crash occurred at 2:45 pm, it only took a few minutes for the Dow to recover from its 1,000 point decline. A market recovery requires buyers, and those value investors who recognized the opportunity of the Flash Crash were able to generate a nice profit on the momentum traders’ hysteria. Ultimately, a stock is a piece of a business, and as long as that business generates positive cash flow then it will be able to invest in growth, pay a dividend, and command a fair price in a takeover transaction. There is nothing disconcerting if momentum traders give value investors the opportunity to purchase these companies at discounted prices, and then potentially sell them right back when those prices become inflated.
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