One unfortunate habit that we commonly see with investors is the tendency to look to short-term market activity for investment guidance. As human beings, most of us are hardwired to defer judgement to the will of the group or at least question our own judgement when the consensus is against us. In some cases, pronounced movements in the stock market can accurately signal a fundamental change in the economy but in most cases, these movements prove to be little more than ‘noise’ created by fear, greed, or the interaction between conflicting investment strategies.
You can generally divide investment strategy (or investment mentality) into four main camps: 1) buy and hold; 2) momentum; 3) value; and 4) pure speculation. Each of these investor types makes buying and selling decisions based on a different set of rules and impacts the market in different ways. The buy and hold investor is the most benign of the camps. They don’t make investment and asset allocation decisions based on current market conditions. This type of investor simply purchases stocks when they have capital available and looks to hold these positions for years or even decades through various market cycles and economic conditions. Momentum traders and value investors, on the other hand, do not invest passively; they actively look for opportunities that they believe can be profitably exploited. Momentum traders make investment decisions based on stock price and volume trends. Increasing stock prices and growing volumes signal the buy opportunity while declining share prices and volumes signal sells. Value investors take the approach of focusing on fundamentals (such as earnings, cash flow, growth and financial position). Value investors want to buy stocks when they are cheap relative to underlying earnings and cash flow and will often purchase companies that have recently experience a price decline or that are largely unknown, untraded or just currently unloved. Pure speculators are less relevant to this discussion but would exhibit buying and selling behaviour similar to that of the momentum camp.
The effect that momentum traders and value investors have on market volatility is polarized. When the market moves in one direction, the momentum traders exacerbate the movement and therefore increase market volatility, by increasing buying when the market is rising and increasing selling when the market is falling. In fact, momentum traders unwittingly work together to generate market extremes. But when market prices move too far in either direction, value investors get involved. When prices get too high, value investors create a dampening effect by selling into the strength as many of the stocks they own have likely become overvalued. The selling results in a slowing or reversal of the previous uptrend, which signals to momentum traders that it is time to sell. As the market weakness persists, more and more momentum trades drive prices continuously lower until stocks get to a point where they start to look undervalued. This signals to value investors that it is time to start buying again which stabilizes the downward trend and once again can even reverse. And so on and so forth, the cycle continues.
Obviously not all investors can neatly be categorized into one of these investment types. Real world investment strategy involves a lot of human behavior and is too complex to be summarized into a few lines of text. Some investors will utilize multiple investment strategies. For example, an investor can purchase on value but then transition to a buy and hold approach. Investors can also purchase on initial momentum but then sell on value. Some investors will subscribe to one strategy in theory but another in practice. Some investors switch between strategies from trade to trade. And in the case of professional money managers, there is also the structural issue of investor contributions and redemptions: the fund manager may subscribe to a value strategy, but if the fund investors decide to redeem in down markets and contribute in up markets, the impact the fund has on the market may be more closely associated with momentum than with value.
Complexities aside, most investors, whether they know it or not, are largely loyal to their respective strategy. Equally true is the growing trend in favour of momentum strategies. This trend, which naturally increases volatility, is being driven by a number of factors. The evolution of discount brokerages and low cost trading has made trading easier from a logistical and financial perspective. Many brokerages also encourage excessive trading by offering lower fees to high-frequency traders and platforms which provide momentum-based research tools. Next, a virtual explosion has occurred in the market in the usage of computerized trading programs that promise to automate the BUY/SELL decision for unsophisticated investors. Of course, legitimate global economic risks and the fresh memory of recent stock market crashes have also made investors more willing to hit the sell button at the first sign of trouble and potentially the buy button when the market appears to be improving. And finally we have the growing influence of high frequency trading (HRT) companies, which have exploded in numbers and importance over the past several years. HRT uses sophisticated computing programs to execute (in some cases) thousands of trades per minute, resulting in profits of a faction of a cent per trade. The impact of HRT in today’s market is becoming more and more evident. Estimates will vary, but the research we have seen is staggering. In August 2011 (an extremely volatile period), Bloomberg reported that the percentage of average daily volume attributable to high frequency trading had exceeded 80% in the U.S. markets.
We only need to look to the Flash Crash of 2010 (also referred to as The Crash of 2:45) for a not so distant example of how momentum trading creates abnormal volatility. The Flash Crash occurred on May 6, 2010, when the Dow Jones Industrial Average plunged about 1000 points and then quickly recovered after a few minutes. This was the biggest intraday point decline in the Dow’s history. On September 30th, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) issued a report on the crash after a five month investigation. The report “portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral.” The report also discussed how immediately before the crash, a large institutional investor sold an unusually large number of S&P 500 contracts. The report concluded that this activity put selling pressure on an already weak market, which triggered high-frequency traders to start selling aggressively, causing a mini-crash to occur.
When we examine how different investment strategies interact with each other it is easy to understand why markets have been so volatile over the last 4 years. There has always been a divide between momentum and value investors. The difference today, in addition to legitimate economic concerns, is that technology has facilitated a trend in favour of momentum trading and the decline in per trade brokerage commissions over the last 10 years may actually be driving firms to encourage higher frequency client trading. But although hyper-volatility is very frightening to most retail investors it actually presents a great opportunity. Ultimately, a stock is a piece of a business and as long as that business generates positive cash flow, it will be able to invest in growth, pay a dividend, and command a fair price in a takeover transaction. There is nothing disconcerting if momentum traders give value investors the opportunity to purchase these companies at discounted prices, and then potentially sell them right back when those prices become inflated.
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