Thursday, June 18, 2009

Joe Saluzzi Comments on HAL9000

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Long time readers will know how often I refer to HAL9000, and bemoan the lack of connection between stock price and underlying fundamentals that has grown before my eyes especially in the past half decade, accelerating year by year in my opinion. For example last summer I wrote

We are just mice dancing between the elephants of capital and their super computers. Just this past week, we found out that hedge funds have passed mutual funds in terms of volume of equity trading, despite controlling far less money. This is their era and the "marginal consumer" dictates the price - and they are the marginal consumer.


While I joke about it, it is actually quite frustrating... a gleeful band of computers are dominating vast amounts of our volume. Hedge funds are but a fraction of the size of mutual funds but anywhere from 30-60% of the trading volume are from this 2-3% of the money in the hedgies. And of the hedgies we have a subsector with the supercomputers churning through an unspeakable amount of trades. Each day the media (and "we" the collective) try to create some story from "what the market is telling us". I believe that has become increasingly nonsensical, and more so by the day. What millisecond anomalies these computers see, they go after - and so much program trading is now "knock off" - when one thing is triggered it sets off a chain reactions in a multitude of PhD programmed competitors across the Street. That has zilch to do with fundamental equity valuation or intrinsic value.

In a stroke of happenstance, Larry Summers worked at DE Shaw [Apr 6, 2009: Larry Summers - No Conflict of Interest; He Pinkie Swears] which ironically enough is one of the biggest quant shops in the world, the home of many said computers. As a proud member of the inner circle and now Plunge Protection Team [May 27, 2009: Daniel Shaffer Notices the "Invisible Hand" aka PPT], if anyone knows how to set off these computers to move these markets "in the right" direction to inspire confidence (i.e. correctly timing mass waves of futures premarket or late in the day) it would be he. Not that I am implying that. (cough)

Hat tip to ZeroHedge for flagging this piece from Joe Saluzzi. Again, many days I feel like the old man sitting on the bench muttering to myself... "that's the crazy guy!". But based on emails I have received over the past 2 years from some formerly on the "inside" of the machine along with seeing more and more guys who have many years in the business talking the same way I do, I'm confidant what I observe simply as an outsider is being confirmed by people far more connected than I'll ever be. Even Mr. Cramer was talking about it last year [Aug 6, 2008: Cramer - Quants and their Machines] Someone is getting rich off this hijacking, right Jim Simons? [Apr 8, 2008: Hedge Fund Manager - Good Work, if You can Get It]
  • James Simons, head of New York's Renaissance Technologies, who came very close to rival Arnold's income last year, has dropped down to the third spot with $1.5bn to $2bn (in pay).

Saluzzi was speaking of a "High Frequency Trading Roundtable" he had attended, so you can read the whole piece here; it is not too long - I just wanted to pull out a few quotes.
  • I attended a roundtable discussion this morning titled “High Frequency Trading: The New World Order”. In case you are not familiar with the subject, high frequency trading is the hottest thing in the equity market right now. Over 60% of equity volume comes from the high frequency traders (HFT). Basically, HFT’s are computers that execute trades with extremely low latency. They live in a world of milliseconds. If your computer takes more than 50 milliseconds to execute, then you are a dinosaur in this business.
  • The high frequency trading business is extremely profitable. Based on the smugness and the smiles on the faces of the panel members, I could tell they were killing it. The exchanges actively court the HFT order flow since it is extremely profitable for them. They are like drug dealers trying to control their turf and the HFT’s are the drug addicts. Making so much money with so little risk is extremely addicting.
  • Our equity market is being controlled by machines that are nothing more than two bit, SOES bandits. They cloak themselves under the mantra of liquidity providers but they are really just locusts and are feeding off the equity market until it doesn’t suit them anymore. Once their profit margins are squeezed to almost zero, they are likely just to move on to a new market. But what damage would they have done? We will be left with a shell of a market that is used to being led around by computers. Real people and real capital are a scarce resource in today’s market.

Also a quick story on this appeared in the New York Times in August 2007 when these quants had a very rough month
  • “These guys all know each other, and they all have the same strategies,” said Ernest P. Chan, a quantitative trading consultant who has done computer-driven research at Morgan Stanley and Credit Suisse. “They came from the same schools, and they get together for drinks after work.”
  • A common thread has often been a rise or fall in prices late in the day, a pattern that many analysts attribute to computer models, which are driving a much larger volume of the trading.
  • In one respect the swoon of these computer-reliant funds is the result of managers, who are faced with a deluge of investor money seeking accelerated returns, using their models to make higher risk market bets by following day-to-day trends.
  • Mr. Chan said this predilection for lemming-style buying or selling from investors using similar computer models could turn what would normally be a market setback into a wider contagion.
Just know as you sit there (as I still make the mistake of doing) trying to make "sense of the price action", this is not your grandfather's, or even your father's casino... err, stock market. Long live HAL.

Humans? Not so much.


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