There Is A High Risk Potential Of An Uncontrolled Algo Selling Feedback Loop

In other words, there will come a day “with actual bad news” when the selling onslaught is so broad, not even BTFD HFTs will be able to resist the sudden avalanche of selling. That’s the day when the increasingly fragile market, one in which “liquidity is the new leverage” will officially break and stocks will “trade outside of the NBBO constituting a genuine flash crash” in a “negative feedback loop that causes more volatility.” A selloff from which there will be no “snap back.”

We bring all this up now because one of the main culprits who have been identified for the relentless selling in recent weeks has been the all-encompassing category of "algo traders", which for the sake of simplicity (if not necessarily accuracy) includes quants, HFTs, CTAs and trend-following strats, risk-parity and vol-targeting funds, passive investors and numerous other signal and factor-based market participants. In fact, earlier this week none other than Treasury Secretary Steven Mnuchin blamed HFTs for exploding market volatility (granted, it was a thinly veiled attempt to deflect attention from both the ongoing chaos at the White House and the Fed's ongoing financial tightening).

In this vein, on Friday another major bank joined Goldman as listing algo traders as the biggest latent threat to the market, when Deutsche Bank's chief international economist Torsten Slok not only said the nearly 20% drop in the S&P can be blamed in part on algos but - in his annual list of 30 top risks to the markets - said that the biggest threat is that "algo-driven, risk-parity fire sale in equities and credit continues."

While the catalog is not meant to be ranked in order of risk severity, Slok told MarketWatch that the risks at the top are of more immediate concerns, and are those which Slok's clients have consulted with him most often.

What is most surprising, is that Slok put uncontrolled algo-selling above such conventional concerns as a global economic slowdown, a spike in the dollar, a semi-failed Treasury auction, a spike in US yields and/or inflation, quantitative tightening, Italy's fiscal situation, a housing market crash, a Chinese crash, and so on (understandably, a bank run on Deutsche Bank was missing from the list of 30).

So why is Slok so scared of algos?

"I have a Ph.D. in economics. I am the chief international economist at Deustche Bank Securities, and I spend all day thinking about the explanations of why the stock market goes up and down," he told MarketWatch. "Usually there’s a good explanation, be it from earnings revisions, new economic data or surveys of sentiment."

"The very unique thing about markets since October is that we have on all three fronts seen little change whatsoever,” he said. “If you look at all these data, it is just really strong, and it can’t justify the decline we’ve seen in the stock market."

So, in picking up where Mnuchin left off, Slok merely assigns the "incomprehensible" selloff on those who often trade without a clear reason or logic.

"If you can’t explain why the market is moving, you should be suspicious of the moves the market makes," Sløk said, adding that the rise of algorithmic trading and rules-based investment strategies like risk-parity investment funds can likely take the blame for the outsized moves in the market we’ve seen in recent weeks.

As a result of the dominance of algo trading, Slok argues that momentum has emerged as the most important force in markets, something we have claimed for year. However, one key reason why trading has become so complicated for most, and certainly the algos, is that there is currently virtually no momentum in the market - with the MTUM ETF which tracks momentum stocks having its worst month and quarter since its 2013 inception - results in making any attempt to piggyback on the market a money-losing trade.

 

What does that mean for traders? According to Slok, investors, or rather their computers, "are selling because stocks are falling, not because of changes to the fundamentals." Indeed, the more stocks fall, the more selling emerges; just this past Thursday we noted that according to Nomura, for the first time in three years, CTAs had just flipped net short, suggesting that any further selling would only result in more shorting - and selling.

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Disclaimer: Information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any ...

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