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JP MORGAN STUDY ON DECEMBERS SELL-OFF

One of our key market themes remains “Rise of the Machines/Computers Gone Mad.”

  • Market moves to the downside when they occur will be amplified, gut-wrenching and leave us scratching our heads as to what happened (think December of last year).
  • We need to get used to these episodes.

Approximately 30% of trading is now due to algorithmic based strategies executed by computers. Many of these strategies use momentum as an input. When a stock price is going up with low volatility, the signal is to buy. Money gets sucked in slowly over time. However, when the volatility increases and the price begins to reverse, the signal is to get out asap.

Too much money is chasing these strategies and when everyone heads for the exits, there is not enough liquidity to handle the selling.

JP Morgan’s derivatives team led by Marko Kolanovic studied December’s sell-off and concluded:

  • Low market liquidity was a major cause of the turmoil at the end of last year. This risk will persist going forward and is a paradigm shift.
  • Traders had a hard time executing orders in the volatile markets.
  • Liquidity was 1/3rd of what was in place during previous sell-offs from 2010-2018 and ½ of what was around last decade.
  • The next crisis may be “severe liquidity disruptions” due to systematic trading strategies where humans are not intervening in markets
    – Higher volatility triggers these computer-based models to sell which begets more volatility and more selling
  • With more investors using index/passive strategies, investor demand for stocks by bargain hunters (value investors) is lower than before

We have been aware of this risk for several years and are using strategies to help mitigate the downside risk. In addition, we look to capitalize on the machine’s shortfalls – when prices disconnect from fundamentals, opportunities become present.

Source of data: https://www.businessinsider.com/stock-market-investing-latest-sell-off-and-recovery-showed-paradigm-shift-jp-morgan-2019-4