Stocks have lost much of their ability to forecast future economic and business conditions. Ownership of a stock is a claim to a company’s future earnings and assets. When the future looks bright, stock prices go up. The opposite is true when future earnings prospects dim. Since the future of almost all businesses is highly correlated with the strength of the economy, stock prices have traditionally been a fairly good forecaster of the economy.
However, the percentage of stock owners who actively make buy and sell decisions has decreased substantially. The machines have taken over. Computer driven algorithmic trading now accounts for 90 percent of daily trading activity. Most of that “algo” driven trading is not based upon a fundamental view of a company or the economy. Rather, it is designed to capture or create short-term momentum in prices, or it is programmed to rebalance the assets in a fund based upon the relative price moves of those assets.
While computer program trading has increased geometrically in volume, individual investors have become significantly more passive. An increasing number of individual investors now use a passive investment strategy which assumes that it is best just to stay invested while continuing to make the same monthly 401k contributions regardless of market direction, because, “the market always comes back.” I have written many times of the fallacies in that strategy.
The point of this article is that there isn’t a lot of trading which currently takes placed based upon individual stock selection and investors’ views of the future. Machines push prices around on a daily basis while most investors just continue to make their monthly 401k allocations, regardless of market direction.
This has a tendency to push prices higher. Passive investing creates a consistent reoccurring demand for stocks. And, given that markets have moved higher over the last several years, it is reasonable to think that the computer algorithms are designed with a skew toward upward price movement and momentum.
Much of the algorithmic trading takes place based upon “the machines” ability to scan and trade on news releases and headlines in a fraction of a second. The machines execute large buy and sell orders before the news even reaches most of our desks. It has gotten to the point where program traders seek an advantage by locating as close to the exchange as possible because even in a world of fiber optics geographic location can provide a millisecond of an advantage in executing a buy or sell order.
As an example, the share price of Apple has performed poorly over the last couple of months. On Dec. 4 the price was trending lower throughout the day as broad stock market indexes sold off substantially. At about 12:30 p.m. that day the price of Apple jumped over $5 in a matter of minutes. Apple’s price jump, triggered by an announcement of share buy-backs, pulled the entire market higher, reversing more than a 500 point loss on the Dow Jones Industrial Average.
Do you really believe that Apple’s price reversal signaled such a large reversal in the fundamental view of the economy, earnings, and business prospects? I do not. The move was driven by the machines, programmed to capture news and create and capture price momentum. It quickly spread from Apple to the entire market.
So why have markets fallen recently? There are enough traders, investors and funds who still do take positions based upon a longer-term view of earnings and economic conditions that in the absence of the machines trying to drive prices on an intra-day basis, it doesn’t take too much in a mostly passive investment world to move stocks in the other direction.
In conclusion, a huge percentage of daily stock trading is driven by algorithmic trading programs. At the same time, most investors follow a passive investment strategy, which means that on an intraday basis prices are controlled by the machines. The machines are not programmed with a long-term view of economic activity and strength. Don’t read too much into daily stock market movements.
Nielsen has worked in capital markets for 25 years with a focus on fixed income portfolio and risk management. He has an MBA from George Mason University and holds the Chartered Financial Analyst designation. He currently works for Opportunity Bank of Montana.