The Rise of the Machines
by Kevin Dehod
As we reflect on 2018 market performance, it is very clear that volatility returned with a vengeance. While this volatility was triggered by fundamental economic factors like rising US interest rates, global trade disputes, and concerns of a US recession in 2019, we believe that market volatility is and will continue to be greatly enhanced by the rise of machines that are conducting a good portion of the daily trading on global markets. By the “rise of the machines”, we are referring to the world of quantitative computer trading and a specific trading system within this domain called “algo-trading”.
What is Algo-trading?
Algo-trading is the process of using super computers programmed to follow a defined set of instructions (an algorithm) for placing a trade in order to generate profits. Algo-trading has disrupted the structure of the market and now makes up a significant amount of the daily trading volume on US and Global Exchanges (Figure 1).
Figure 1: The market share of algorithmic trading has grown across asset classes and regions.
Source: Aite Group, Goldman Sachs Global Investment Research
Should investors shift money away from human investment teams to machine teams?
Although our research team is in favour of utilizing computing power and formulas for screening in the initial stages of our investment process, we firmly believe in the benefits of having a human team researching and carrying out investment decisions. Algo-trading strategies utilizing super computers process immense amounts of data, unearth patterns, and follow rules-based trading strategies with little regard to WHY markets are moving, only that they ARE moving.
Take this past Christmas as an example. The US stock market experienced the largest percentage loss ever recorded on Christmas Eve (down 2.7%) – only to experience the largest one-day percentage gain (5%) since March 23, 2009 on Boxing Day. Did economic conditions change that much between Christmas Eve and Boxing Day?
As fundamental (human) investors, we’re able to conduct deep analysis to uncover the WHY and take advantage of market volatility especially when there is a large gap between the current stock price and the underlying intrinsic value of the business. Sometimes we may be early in our investment decision or wrong, however we will utilize our research process as a guide to navigate these situations as they arise.
One of the many challenges for investors with these elevated levels of volatility is the temptation to abandon your long-term investment plan and try to time the market. In my experience over the last 25 years you will be tested and tempted to abandon your investment principles and plan when you need it the most.
One of the principles that one of my mentors shared with me and that is crucial in navigating today’s markets is time in the market vs. trying to time the market.
“Time in the Market” will yield success, not “Timing the Market”. It is impossible to consistently time when to be ‘in’ and ‘out’ of the market. If you invested in the US stock market from 1997 to 2017 and stayed invested through the volatility, you would’ve achieved a 7.2% annualized return. For those that missed the 30 best days over this period because you were in and out of the market, your annualized rate of return went down to -0.9%.
Figure 2: Risk of missing the best days in the market 1997-2017 (S&P 500 Index).
Benjamin Graham, who was one of Warren Buffett’s mentors and teachers said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” So in the short run, algo-trading machines are causing a lot of voting noise, and this noise is creating selective investment opportunities within global markets. As fundamental investors, we remain disciplined in adhering to our investment philosophy and process, and we will utilize our process to take advantage of investment opportunities.
Our research team is hosting their next luncheon with our clients at the end of January to reflect on the past year, discuss what we are doing in our portfolios and how we are positioned for 2019 and beyond. We will be releasing our next copy of the Outlook Commentary to our clients where we elaborate on the theme of the current “Slowing, but Growing” environment we are currently in. If you are interested in receiving a copy, you may register here.