My Two Cents - "Today's Irrational Market and the rise of the Propellerheads - Fred Carach"

08/29/2008

When I broke into the stock market in 1961 the stock market was a far more rational market than it is today. The type of news that will send a stock up or down four or five points today would have in the 60s and 70s only sent the stock up or down a half point. The stock market today resembles to an ever increasing degree a" perpetual overreaction machine". It is forever being jerked around like a monkey on a chain. One constantly hears alleged market authorities proudly proclaiming that the market is always looking forward six months. Not any more! Today's market is too stupid to anticipate anything. It does not anticipate it reacts in shocked surprise and with with ever increasing violence.

The question is what has brought about this dramatic change in market behavior? The answer is that the market players and their relative strength has changed. And the most important new factor by far has been the rise of the "propeller heads" as they are fondly called on the street. Their common name is Quants because they are engaged in quantitative analysis. By the 80s it had became fashionable for Wall Street firms to raid college campuses for math PhDs. Then stick these certified geniuses into a room with a high-powered computer and tell them to come up with a sophisticated black-box algorithm that would enable them to beat the market. And in many cases they succeed. And thus computer-generated program trading was born. The other key players in this drama were the day-trader and the momentum player. Both of these players had long existed but until the 80s they were small potatoes. In the 60s when I started out the stock market was dominated by the individual investor. The individual investor in those days was overwhelmingly a "conviction investor". He researched stocks as best as he was able to and based on this research and his convictions (he liked the product). He bought the stock. By long-term I mean at least five to ten years. Today long-term means I might own the stock six months as long as it doesn't go down 5%. If it goes down 5% I am out of there. It is important to understand the distinction between a market and mob-action. A market requires the prudent, informed, carefully calculated and above all else "independent-opinion" of the entire mass of the decision-makers who make up this market. In the absence of these independent decision makers you don't have a market you have a mob that is pretending to be a market. This results in ever more violent reactions to the news of the day that can not possibly be justified when you analyze the economic realities of both stocks and the market. This assumes of course that anyone is still paying attention to tried and true fundamental analysis. After all why waste your time with this boring stuff that may only pay off in the long term when you can participate in the excitement of the street's latest cattle stampede. Even if it is heading off a cliff.

After all we are smarter than the average herd animal aren't we? There is no doubt that we will spot the cliff before the rest of these clowns. Did you ever see a more confused herd of sheep and goats? I don't think they could find a cliff if they tried to! My god how did that cliff get there? Help!!! Historically the stock market was soundly based on masses of independent decision makers. As time passed however, these independent decision makers were gradually replaced by the rise of the institutional investors who for all of their alleged vaunted sophistication showed a much greater tendency than the individual investor to stampede with the herd. The transfer of market making power from the individual investor to the institutions resulted in a vast reduction in the number of independent decision makers.The growing tendency of the institutions to concentrate on short term profits and to participate in every cattle stampede went on steroids when the propeller heads arrived on the scene. Their magic black boxes based on their secret algorithms promised and more often than not delivered superior short-term returns. Long term investment went out the window. The future was now. As this bias took over the market the day traders and the momentum players exploded in importance. As time progressed many of the black box programs seeped down the food chain and became more readily available to them. It was found to be impossible to keep the most successful programs secret for long. As a result everyone began to march to the same drummers. During this period the ranks of the old time conviction investor with his independent viewpoint and long-term holding pattern shrank to insignificance. And thus was born today's whiplash market. Strangely enough for an old school investor like myself this new world order is a gold mine.The only thing I have to do is hide in the weeds and pick off the game as they thunder pass me in one of their mindless stampedes.