Algos Gone Wild
There are a lot of reasons for the markets to be doing what they are doing this week. The election and the situation in Europe are chief among those reasons. Yet I can’t help but think that positioning remains the biggest problem (I will post my “crowded trade” memo from last night for those who aren’t on e-mail distribution). But on top of positioning, it seems clear that the market has drifted ever further from any attempt at valuation as is merely a playground for algo’s and technical analysis.
I am not sure I’ve ever heard or read the term “200 day moving average” as much as I have over the past two weeks. In fact, I may have read it and heard it more these past two weeks than I have in the past 5 years combined. Everyone is a technical analyst. Certainly one explanation for yesterday’s trading was that lots of people bought the 200 DMA (on S&P – ignoring for the moment that Nasdaq is well through its 200 DMA). That supported the market, but as selling pressure continued to weigh on the market, those that had bought for the support of the 200 DMA sold and some shorted the potential breakthrough of the 200 DMA. If this sounds like gobbledygook to you, well, it isn’t.
Self Fulfilling or Recipe For Disaster?
For many of you out there that hate technical analysis and chartists, well you are out of luck. They are important. If it seems arbitrary that the 200 DMA is used rather than 215, it probably is, but it doesn’t mean you can ignore it. The same goes with head and shoulders patterns, plunging necklines, Fibonacci retracements, and beyond.
With so many people looking at these technical signals, they can become self-fulfilling. When everyone expects we get support at a level, they buy and we get it. It works. The problem is when it doesn’t work. When people buy at the support level and we get negative news. Now they are sellers. They only owned it based on a technical level. For those who live and die by technical trading, that is something they are used to. For technical “tourists” it is dangerous. The PM who has spent 95% of his or her life focused on P/E but is playing the “technicals”, is dangerous. Now the selling accelerates, because not only do those people who bought need to sell, but many real technical traders, not to mention momentum traders, will now see the breach of the 200 DMA as a great opportunity to short. So momentum to the downside will accelerate to downside as people look for a much lower resistance. This is about the time when Elliot wave talk begins – as those tend to be longer, bigger moves.
There are two problems with technical trading that I see in this market. The first problem is that so many people are doing it, that it will seem to be working, until the time it doesn’t, and that time will be horrific. The second and bigger problem is that computers are better at it.
Computers and Charts
We humans like charts. They let us visually represent something. We can draw lines and see patterns. Computers don’t need charts. Charts are just a visual representation of data, and the computers can rely on the data itself. They can scan data for any pattern in any time frame far faster and more efficiently than humans. They will always be ahead of the curve. Algos don’t “know” anything, but they are programmed with trades looking to test these technicals. They will push prices towards them looking to cause breaches or support.
So you have humans all playing the same trade and algos “helping” them along. On far too many days lately, this is the best explanation for what is going on.
Mind boggling that we are back on the verge of what looks like the EU ripping itself apart by letting Greece go. I still don’t see how the EU sees “OSI” or official sector losses as unacceptable, but expects to get paid if Greece is forced to default or exit? I can’t figure out the logic there. They are contradictory and the only real option for the official sector is losses in an organized and methodical approach while trying to help Greece, or losses in a chaotic default with lawsuits and massive spillover effects into the rest of Europe. Bizarrely, Spanish and Italian bonds are well behaved today.