It's a good time re-visit a concept that I wrote about in late 2010 about market variability and systems failure, in a piece called A Fingerprint of Instability in Biology and Finance. The basic idea is that complex systems with an underlying fractal structure maintain some level of stability through localized and unpredictable variability, or what’s frequently referred to as an emergent "order out of chaos". We see this dynamic clearly displayed in the cardiovascular system of humans - a healthy and stable heart is characterized by a chaotic beat interval pattern, while the heart of a person in ventricular fibrillation has collapsed into much more regular intervals.
The piece then described how this “fingerprint” has become evident in the realm of finance, focusing on the role played by high-frequency trading (HFT) among fewer and fewer market participants over the last decade in destroying the healthy variability that is characteristic of stable markets. That variability comes primarily from the natural differences in time horizons, asset allocations, investment expectations and trading volume that exist between market participants. The following excerpt briefly describes the “fractcal markets hypothesis” and gives an example of why market variability is such a critical aspect of market stability:
Related to Sornette's work is the "fractal markets hypothesis", which has been explained simply and coherently explained by the Australian economist Steve Keen in a slide lecture he produced and made available to the public. . To summarize, this hypothesis suggests that the stock market exhibits deterministic chaos, making the short-term movements of prices extremely impossible to predict.
Similar to the healthy human heartbeat, the market achieves aggregate stability when investors have variable time horizons and expectations for their investments. In contrast, a speculative bubble is formed when many investors share the same expectations, imitating each other's decisions to buy, and a market crash occurs when they all "rush for the exit" at the same time. [Slide 36]
The reason why variability of time horizons is so important for market stability can be explained with a simple example. Let's compare an average day trader with a five-minute time horizon to an institutional investor (such as a pension fund) with a weekly time horizon from 1992-2002. The average five-minute price change in 1992 was -0.000284% (an overall "bear market"), with a standard deviation of 0.05976%. A six standard deviation drop (-.359%) in price during that time period could easily wipe out the day trader's investment if it continues.
The institutional investor, on the other hand, would consider that drop a buying opportunity since weekly returns over the ten-year period averaged 0.22% with a standard deviation of 2.39%. The relatively large drop for the day trader is basically a non-event for the weekly trader's technical/fundamental outlook, so the latter can buy the dip and provide stabilizing liquidity to the market.[Slides 38-39]
As the graphs above indicate, it is not just investors’ time horizons that have lost most of their variability with the inexorable rise of HFT, but also the differences in the number of stocks traded and the volume of those trades. And the situation has only become worse since that time. From mid-2011 to the first month of 2012 was a period marked by an unprecedented drop in volume for the S&P 500, while European markets have followed similar trends [As the No-Volume Market Churns]. This was also a period of great volatility in markets, with frequent episodes of systemic fear gripping these markets by their throats in the Fall of 2011.
Indeed, U.S. markets finally ended a gut-wrenching 2011 barely changed from where they started the year. The only thing investors gained from the tumultuous market that year was painful whiplash and heartache, as well as the prospect of even more instability in the future. One of the key drivers of this greatly decreased variability in the market over the last few years had been the unabated exodus of the retail investor, who could no longer endure the torture and had completely yielded to robotic traders.
As the graph from ZeroHedge shows above, U.S. domestic equity mutual funds had an outflow of $3 billion in the week of February 29, the largest in 2012, which brought the total outflows to $66 billion since November 2011. This trend is an important reminder of how market instability does not necessarily equal a market crash or collapse - all of these outflows occurred during a 20% rally in the market from its October lows. The growing instability (decreasing variability) simply weakens the potential for the system as a whole to absorb any triggers of widespread fear when they inevitably arrive.
People investing their capital through mutual funds and pension funds have traditionally been the source of variable time horizons, investment sizes and allocations for the equity markets, but they are all but out of the equation now. What’s perhaps more interesting is how even the limited variability provided by HFT market participants is now in the process of disappearing, as the robotic traders who can longer compete are weeded out. Boyd Erman speaks to how this issue has rapidly metastasized in Canada for The Globe and Mail:
Retail investors, after gutting it out through years of awful returns, have finally fled. In a normal market, retail participation – Mr. and Mrs. Public trading their personal accounts – should be about 20 per cent. That plunged in November and December, traders say.
Professional portfolio managers are also sitting on their hands in cash, or moving to fixed-income or alternative investments. Take the Canada Pension Plan Investment Board as an example. In recent years, the pension fund manager has increased its holdings of bonds and what it calls inflation-sensitive assets (roads, bridges and other infrastructure). But its equity portfolio isn’t much bigger than it was five years ago.
There’s also the fact that regulation is becoming unfriendly, especially to hedge funds and proprietary traders. The amount of capital that banks can profitably hand to their trading desks to use is in decline.
Perhaps the most likely candidate for the drop-off is a decline in activity by the same high-frequency traders who helped boost volumes so dramatically in the preceding few years, and who now constitute roughly a third of the market by many estimates. So-called HFTs were drawn to Canada by incentives from markets such as the TSX, and by the opportunity to trade against investors big and small who weren’t wise to their tricks.
The market is suddenly tougher for HFTs. Some strategies have become so competitive that they are less profitable, regulation is become steadily tougher on them, and Canadian investors who were easy pickings for HFTs have learned to deploy countermeasures.
In the past, it has been easy for most people who work outside of finance to be misled by the short-term movement of markets; they see flashes of green in their occasional glimpses of the news and take them as a sign that the economy/markets are healthy and all is well with their portfolio. Since 2008, that perspective has obviously become more difficult to maintain over time, especially for those working within the field of finance and managing money on a daily basis. On top of that, the people (robots) that had become the only source of consistent volume for the markets, high-frequency traders, are now devouring each other.
Returning to the U.S. markets, Peter Chapman for Traders Magazine has also picked up on this underlying trend in the publication's featured story entitled, Fear Factor.
On Wall Street, risk is suddenly a four-letter word. Retail investors can't stomach it. Pension plan sponsors are allocating away from it.
"Our bread and butter is the retail investor," Scott Wren, a senior equity strategist at Wells Fargo Advisors, one of the country's four largest retail brokerages, told Bloomberg Radio recently. "They're not jumping into the market. They're not chasing it. Those who have been around for a little bit have been probably burned twice here in the last 10 years or so. They're definitely gun-shy. They're not believers. I'm not sure what it's going to take to get them back in the market."
Their financial advisers aren't sanguine about the U.S. stock market, either. Only 44 percent of them plan to increase their clients' allocations to U.S. stocks this year, according to a recent survey by Investment News. That's down from 63 percent at the start of last year.
Pension plans, which own about 20 percent of all U.S. equities, are following individual investors out the door. As a result of the stock market meltdown, both public and private defined benefit plans are underfunded, as their assets have fallen below their liabilities. And because they must earn a return regardless of stock market conditions in order to pay retiree benefits, they are as worried as retail investors.
So, as noted in my original piece, the natural and variable heartbeat of most equity markets worldwide, and especially in the U.S., has been completely eradicated, leaving the “brain” starved of oxygen for much too long. There is no cognition, creativity or conscience left - only the mundane and de-humanized life of patients who are being kept alive by an assortment of machines. However, even the machines are running out of the energy required to keep them powered on, because liquidity is no longer enough for the big money players. The hope of witnessing the market bounce back to a healthy and stable life has been overtaken by the pain and agony of watching it die.