Saturday, July 23, 2016

A Fully Automated Stock Market Blow-Off?

Anecdotal Skepticism vs. Actual Data

About one month ago we read that risk parity and volatility targeting funds had record exposure to US equities. It seems unlikely that this has changed – what is likely though is that the exposure of CTAs has in the meantime increased as well, as the recent breakout in the SPX and the Dow Jones Industrial Average to new highs should be delivering the required technical signals.
 robot traders
The bots keep buying…

All these strategies are more or less automated (they may be tweaked from time to time, but essentially they are simply quantitative and/or technical strategies relying on inter-market correlations, volatility measures, and/or momentum). Active fund managers by contrast are said to be skeptical of the market rally, but it should be stressed that the evidence for this is purely anecdotal.
The vast bulk of trading is nowadays automated. We recently read that in 2015, 23% of the entire year’s equity trading volume was accounted for by the top 100 ETFs (h/t to Brent Johnson of Santiago Capital). These are passive investments – in other words, they are brainless.
In addition to this, some 50% of volume is probably attributable to high frequency trading, and the above mentioned black box strategies presumably account for a good chunk of trading volume as well. This raises an interesting question: how many trades are still made by someone who actually thinks about what he is doing? Does it even matter whether active fund managers are skeptical or not?

It looks pensive in this image, but does it actually think? We don’t believe so…

What prompts us to wonder about this is the following chart. It shows the so-called “smart-dumb money confidence spread” calculated by sentimentrader, which tries to show what historically good and bad market timers are doing with their money. Its construction involves mainly real money gauges (for instance options and futures positioning data, short selling data, odd lot purchases, etc.) rather than “opinions”.
Admittedly, in bull markets the spread appears to be better at catching lows than highs, but when it reaches a rare extreme, it is probably worth paying attention to it. Based on this chart (and the next one), one could easily get doubts about the “anecdotal skepticism” mentioned above.
We know though that such skepticism exists, because “tail risk premiums” remain quite high. For instance, the SKEW index still stands at approx. 128 after spiking to a record 155 in June and the CSFB fear barometer remains at an elevated level as well – this indicates that far ootm SPX put option protection remains fairly expensive on a relative basis, in spite of the sharp decline in the VIX.

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