By Kirk Spano
In 2007, I started studying algorithmic-trading and trend-following-based models of investing. I knew I needed an early warning system for the crash I saw coming. I discovered the "Turtle Traders" and learned more math and programming than I thought my brain could handle. Over the past several years, kids much smarter than me have far surpassed what I could ever have done as a "quant."
What I learned, though, opened up another world of investing to me that coincided with the rise of Exchange Traded Funds (ETFs). I have both followed and learned from the algorithmic ETF traders. The most important thing I have learned is that most of their formulas are similar and similarly flawed.
In short, what these traders are doing is using heavy-duty, mathematical, momentum-based trading models to dictate their trading decisions. If they get a sell signal, they robotically sell. If they get a buy signal, they robotically buy. They claim this is the best way to eliminate poor emotional judgments from their investing. There is certainly some value in that, as many of these traders are overemotional (question their models to hear how emotional) and poor judges of investment value.
In fact, the best trend traders do very well. But over the past decade, there has been a slew of copycats, and not many are winners or worth their weight in calculators. Ultimately there are unintended consequences to all of this algorithmic trading. There are opportunities as well, which I'll get to later.
In any case, what is going on now is that these momentum-based ETF traders are getting sell signals, so, they are selling ETFs. Until the last trend followers sell — the back of the herd — there will continue to be selling.
When there is mass ETF selling, the stocks that comprise those ETFs have to be sold by the ETF sponsor. The most popular trading vehicles for the trend followers are the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY -0.41% , the iShares Russell 2000 ETF /zigman2/quotes/209961116/composite IWM +0.24% , the PowerShares QQQ /zigman2/quotes/208575548/composite QQQ -0.93% and the iShares MSCI Emerging Markets ETF /zigman2/quotes/201454250/composite EEM -1.56% . Each has had volume over the past 30 days exceeding $60 billion a day. You can see why the market is falling. There is significant volume moving in the same direction — down.
Jack Bogle mentioned on CNBC last Thursday the impact on volatility these ETF traders are having. I agree, as does Mark Cuban who mentioned the likelihood of unintended consequences on TV a few months ago, that these algorithmic traders are worth watching closely. The most likely unintended consequence is that the trend followers will create a self-fulfilling downtrend as other investors follow suit and sell, causing a spiral downward.
The next group of investors to make a decision are the investment advisers who have started to build ETF-based investment portfolios for their clients in the past few years as part of their new sales shtick. We'll see how they behave. Most of them are not very good investors, but luckily, most aren't very creative or motivated to work either so long as their fees are being collected. I doubt there is much of significance that happens there.
The last group that could sell are the mutual-fund investors. I don't think many will sell unless something very bad and loud happens. Usually, they only sell after they see a bad quarterly statement or they get a call from their broker. We're past third-quarter-end, and we know that brokers hate to call when the market is down, so I don't expect big sales there either.
Ultimately, I don't see a collapse, as I mentioned the other day. What I think is most likely, is that the ETF momentum-trader selloff gives investors an opportunity to buy investments to take part in the next phase of the bull market. It makes sense that there is another leg up in the stock markets that will be driven by the release of more of the money created from the Fed's quantitative-easing (QE) program into the capital markets. Most of that money is actually still sitting at the Federal Reserve as excess reserves because banks are collecting interest on it. The Fed as already indicated they will reduce what they are paying for excess reserves to stimulate growth if need be. If the past is any sort of indicator, I think you can count on the Fed to be accommodative for at least the next couple years (through the next presidential election).
I think this correction is giving you an excellent chance to make new investments and rotate into the big trends. Consider taking that opportunity as soon as the downward momentum ends.
Disclosure: Kirk and certain clients of Bluemound Asset Management do not own shares of any of the ETFs mentioned. Neither Kirk nor Bluemound clients plan any transactions in the next three trading days. None of the ETFs mentioned are currently recommended at Kirk's American Resource Boom Letter. Opinions subject to change at any time without notice.