Computerized Trading

Computerized/quantitative trading – based on huge amounts of leveraged capital acquired at insider prices not available to us minnows – drives the stock market. That isn’t a revelation. But it is very difficult to understand what the impact of that activity is on those of us who aren’t privileged to own Cabinet officials and central banks.

Barclays released a graph today that is interesting. Well, interesting to a quantitative geek like me.

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High correlation levels between stocks means that there is little value-added in picking individual stocks. It occurs when the big investment money is most herdlike. And it tends to spike up in bear markets when macro-level issues overwhelm everything else. In technical terms, a stock’s beta becomes far more important than its alpha.

This graph was interesting to Barclays because May and June had the highest correlation levels ever. Higher than Oct 1987 – higher than late 2008 – and higher than any time since 1950 (which is apparently the earliest data point they have). Their conclusion was, not surprisingly, that it proves that one must send all their investment money to big investment houses that have plenty of investment choices based on top-down indexes with different beta choices. Like – eg – Barclays.

The graph is interesting to me because of the marked increasing trend apparent over the last 10-12 years. Stocks have become far more correlated. Not just during bear markets but over the whole investment cycle. It proves the triumph of the “indexers”. Not only have indexers taken market share of the investment $ — but they have also created indexes that capture a much wider pool of stocks. It is those stocks where it is increasingly pointless to waste time evaluating individual companies.

What is also interesting is that there also appears to be a slightly lesser trend of decreasing correlations at the early end of this graph — in 1950 near the very beginning of the recovery from the Great Depression. Indexing did not exist back then and nor did computerized trading. But the trend at both ends of the graph is clear enough to suggest the possibility that these correlations have an ultra-long cyclical component.

That periods of deleveraging and capital DE-allocation tend to withdraw capital/investment from ALL companies – without any serious attempts to differentiate among them. And likewise, a reinfusion of capital/credit after a long absence will tend to lift all boats at first. Only later will there be differentiation of investment – with some investments being winners and other investments losers.

If that possibility is true; then the success of indexing has itself created a massive misallocation of capital. Indexing is about as stupid as capital can be. It makes no attempt to differentiate whether a company is a bunch of crooks or whether it is productive. If it is in an index, it will get investment money. Period. In completely automatic amounts. No thought is necessary. Nor do indexers pay even the slightest attention to corporate governance.

At the macro-level, this misallocation of capital — over a very long period of time and in increasing amounts — may be contributing to the current deleveraging and the specter of asset deflation. At the micro-level, it may indicate some good opportunities among those very few companies that do still actually reward shareowners – even if their stock prices don’t reflect it any more.

At any rate, I found this interesting.

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