In the trading activities of the US stock market, algorithms are engaging in intense contrarian activity. They are buying during a phase where there are significant risks of a market downturn, despite rising interest rates, a slowing economy, declining profits, and even bank failures. Let's explore how these algorithms operate and why we should not fall into their trap.
A thought-provoking article published in the Financial Times on May 14th sheds light on this peculiar phenomenon. It describes the intensive contrarian behavior of algorithms in a market environment that exposes the American stock market to substantial downside risks. Despite rising interest rates, a slowing economy, declining profits, and bank failures, stock markets have experienced an anomalous upward trend.
During this period of high negative uncertainty, algorithmic trading activity, known as Algo trading, has reached its highest levels in the past nine years. This surge has artificially boosted a market that was, in fact, vulnerable to decline. Similar phenomena have emerged in the past, leading many professional and non-professional traders to admit that the US financial market is now manipulated by algorithms, which account for around 70% of daily stock market volumes.
Institutional investors have practically exited the market, and the flow of retail investor trades (now comprising 10% of total volumes) has filled the void left by these institutions. This has been made possible by the advent of zero-commission trading platforms like Robinhood, Charles Schwab, Ameritrade, Interactive Brokers, and others. The zero-commission model is compensated by profits from the interest rates applied to the leverage used by American retail investors, who typically operate with leverage ratios of 2-3 times their invested capital.
Large institutions such as pension funds, hedge funds, sovereign wealth funds, and family offices had gradually withdrawn from the US stock market in recent years. This shift was prompted by unfavorable valuations, lack of transparency in balance sheets, and extensive buyback activities carried out by many companies. In numerous cases, these buybacks were employed to artificially inflate earnings per share (EPS) and support stock prices. The continuous outflow of funds occurred notably between 2016 and 2019, as reported by BofA Global Research.
It is also noteworthy that while buybacks have reached record levels in recent months, CEOs of companies have been selling their shares at record rates (source: CDT Capital Management Insider Sentiment Ratio, April 2023). Another confirmation of the declining appeal of the US market is found in a recent newsletter from Berkshire Hathaway, headed by Warren Buffett. The newsletter highlights the lack of opportunities for genuine investors, to the extent that Buffett himself has ventured into the Japanese market for the first time in search of alternatives. The capital migration by major investors had actually begun in 2013/2014, resulting in an annual average outflow of $1.5 trillion. Over $9 trillion has flowed into private markets as a result.
Subsequently, this phenomenon led to the significant boom in Initial Public Offerings (IPOs) as professional investors realized it was more advantageous to acquire unlisted companies at lower valuations and subsequently sell them on the stock market to retail investors and mutual funds. This practice often led to inflated valuations, triggering a frenzy around "unicorns," companies whose profitability often existed only in fairy tales. Unfortunately, the migration from liquid to illiquid assets created an additional speculative bubble in private markets. Currently, institutional investors find themselves trapped in illiquid assets with high valuations and, for now, low profitability.
The collapse of Svb, a bank that suffered losses from mortgage-backed securities (MBS) and Treasuries, highlights this situation. In reality, it was the
continuous injection of liquidity from the central banks that prevented mini-crises from turning into major crises. The so-called "Japanification" of the US market is now in full swing. However, as we have highlighted numerous times, this system cannot prevent the constant deterioration of fundamentals, which will eventually lead to a crisis. Instead, it aims to divert attention from the underlying dynamics, rendering the system increasingly discredited.
Furthermore, algorithms are programmed to focus on short-term events, ignoring the medium to long-term risks and consequences. This programming is driven by the media's continuous emphasis on news that favors positive short-term outcomes while downplaying events with potentially negative long-term consequences. For example, algorithms interpret rising interest rates as a transitory phenomenon that will gradually diminish over time, while human investors may recognize its potential negative impact on the economy and corporate profitability in the future.
In conclusion, the US stock market is currently operating under the strong influence of algorithmic trading, which has created a disconnect between market behavior and the underlying economic fundamentals. The overreliance on algorithms, coupled with the concentration of trading in a few large companies, is leading to a manipulation of short-term market indices and a fragility within the market structure. While this system may prevent immediate crises, it cannot evade the continuous erosion of fundamentals, which will eventually trigger a full-blown crisis. It is crucial for investors to stay vigilant, question the prevailing narrative, and reassess their investment strategies accordingly.
Disclaimer: This text is a summary of the article published in the Financial Times on May 14th, 2023, and does not constitute financial advice.
Follow us for More and check out our GUIDES - FOR FREE ON KINDLE UNLIMITED
Link doesn't work? Check exafin.net on your fav browser.
Comments