- New Technology May Cause Stock Volatility
- Should Investors Focus on the Long Run?
- The Role of Technology
- Using Theory to Account for the Facts
- New Age Of Stock Market Volatility Driven By Machines
- March 2020: Fastest Bear Market in History
- Machines Behaving Badly: Faster than “Blink of an Eye”
- Evidence of Recent Algorithmic Damage
- Can’t Beat Them, Join ‘Em
- 4 Ways Stock-Market Volatility Affects Every Business
- Consumer behavior
New Technology May Cause Stock Volatility
Sunday, April 1, 2012
The fact that the market value of firms traded in U.S. stock markets displays considerable fluctuations over short time periods is very well-known and receives a great deal of attention in the press.
From the perspective of economic theory, this elevated level of short-run volatility in the stock market is very challenging to understand because fundamentals—i.e.
, variables that one would consider key determinants of market values, such as profits, dividends or output growth—do not fluctuate nearly as much.
Should Investors Focus on the Long Run?
From a macroeconomic perspective, if stock market volatility were confined to short-term horizons, then it would not be of great concern because the volatility would wash out in the long run. However, the stock market displays pronounced movements that are also long-lived. The relevant data are summarized in the figure.
Click to enlarge
Market value of U.S. corporations in real terms and in log scale. Each decimal point on the log scale represents approximately a 10 percent change.
SOURCE: Table L213 of the Flow of Funds of the U.S. (shares at market value) divided by the GDP deflator taken from the U.S. National Income and Product Accounts.
The stock market value of all publicly traded U.S. corporations increased at a very fast pace during the 1950s. During the 1960s, it slowed down substantially.
Stock market values declined by 57 percent from their peak in 1972 to 1974 and did not start growing until the 1980s. From the mid-1980s to 2000, equity values rose steadily, more than tripling.
From 2000 to 2010, in spite of large year-to-year fluctuations, equity values did not display any particular trend.
The welfare implications of such strong changes in market valuations may be profound. An individual considering retirement in early 1974, for example, would have seen her stock market wealth go down by 50 percent in that year.
More important, the stock market did not recover from this negative shock until well into the 1990s. Retirement prospects would look very different for somebody considering retirement in about 1990.
By then, the stock market had recovered, and a twofold increase in valuations would take place during the following decade.
The Role of Technology
One of the possible explanations for the observed changes in the long-term trends in the stock market is changes in technology.1 The production structure of the U.S. economy has been transformed at its most fundamental levels during the past four decades, and these changes are reflected in asset valuations.
First, the U.S. economy slowed down substantially about the mid-1970s as productivity growth was cut in half and stagnated for the next two decades.
This is the famous productivity slowdown, which might also have signaled that existing technologies and production methods could no longer continue to be the engines of growth.
2 Historically, firms that are traded in the stock market tend to be well-established firms that are, therefore, more ly to use established technologies. As a result, the slowdown in productivity might have affected, in a particularly strong fashion, publicly traded firms and their market valuation.
Interestingly enough, some small, incipient sectors of the economy were experiencing a productivity boom simultaneous with the productivity slowdown of the mid-1970s.3 The 1970s, and most certainly the 1980s, signaled the beginning of the information technology (IT) revolution.
Many of the major economic players of the 1990s, and even of today, were born in the middle of this revolution. However, most of the firms employing these new technologies would not go public until the late 1980s or early 1990s, and only then would stock markets start to recover.
Using Theory to Account for the Facts
To better understand how the aforementioned technological shocks might translate into stock market fluctuations, it is useful to recall some basic economic principles. A key complication behind stock market valuations is that they are forward-looking by nature.
Ownership of a share of equity entitles the holder to a fraction of the stream of future dividends distributed by the firm and to the expected capital gains (or losses) that may result from selling such a share.
The value of shares must, therefore, equal the expected discounted value of dividends plus expected capital gains.
Using this basic theory, think about the possible impact of the mid-1970s slowdown in existing technologies. Since the stock market had reached a period of relative stability during the 1960s, people might have thought that dividends would grow at a relatively stable rate for years to come.
As a back-of-the-envelope calculation, consider a fictitious firm that pays an initial dividend distribution of $100 and that the expected dividend growth rate is 3 percent per year (which corresponds to the average growth rate of the U.S. economy during the 1960s).
If the interest rate is 5 percent (the average during the relevant period), then this firm is worth $5,250.4
The productivity slowdown can be thought of as a sudden decline in the expected growth rate of the economy, from 3 percent to 1.5 percent. Let's further assume that this slowdown is perceived to be long-lasting. According to the theory, the value of the firm is now updated to $3,000.
These numbers imply that a sudden slowdown in the expected growth rate of the economy may translate into a drop in the stock market! It is important to notice that dividends do not have to fall for the stock market to fall. The perception of a slowdown in the expected growth rate of dividends is enough to generate large changes in stock market prices.
Hence, basic economic theory seems to be useful to understand the stock market crash of the mid-1970s.
What about its subsequent stagnation and eventual recovery? Microsoft, Cisco, Yahoo and the are products of the information technology revolution. But IT firms did not start trading in the stock market immediately.
Indeed, data show that firms take 20 years on average to go from main initial innovation to actual listing in the stock market.5
IT-producing firms were important forces driving the recovery of the stock market of the 1990s. But to move the stock market overall, it is necessary that a large number of firms and sectors recover in value. And this is another reason for the stagnation in the 1970s.
New firms have the comparative advantage in adopting new technologies, and adoption of new technologies takes time.
The recovery in the stock market, therefore, was delayed because the firms and technologies that would bring growth back did not enter in full force until decades later.
- These ideas are explored in a fully blown general equilibrium model in Peralta-Alva. [back to text]
- See Griliches for a survey of the productivity slowdown literature.
[back to text]
- Productivity decompositions by sector, with an emphasis on measuring the productivity of the information technology sector, can be found in Jorgenson.
[back to text]
- The present value of a flow that starts at value X and grows at rate g discounted at rate r is (1+r)X/(r–g). [back to text]
- See Jovanovic and Rousseau. [back to text]
Griliches, Zvi. “Productivity Puzzles and R & D: Another Nonexplanation.” Journal of Economic Perspectives, Vol. 2, No. 4, 1988, pp. 9-21.
Jorgenson, Dale W. “Information Technology and the U.S. Economy.” American Economic Review, Vol. 91, No. 1, 2001, pp. 1-32.
Jovanovic, Boyan; and Rousseau, Peter L. “Why Wait? A Century of Life before IPO.” American Economic Review, Vol. 91, No. 2, 2001, pp. 336-41.
Peralta-Alva, Adrian. “The Information Technology Revolution and the Puzzling Trends in Tobin's Average Q.” International Economic Review, Vol. 48, No. 3, 2007, pp. 929-51.
New Age Of Stock Market Volatility Driven By Machines
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The Dow broke many records in March of 2020. We saw the fastest bear market in history, the largest one-day gain in history, and the Dow had its worst first quarter since 1987.
Many more records were broken on the intraday level. For instance, fourteen trading days between February 25th and March 20thmade the top twenty list for largest intraday swings. According to Wikipedia, nine of the top ten positions occurred in a span of three weeks between March 2nd and March 20th.
Throughout the generations, there have been world wars, depressions, recessions and financial market implosions, but this is the first market to be whipsawed by machines. What’s driving the intensity is algorithms which puts wealth preservation at stake as retirement funds compete against quant traders.
Flash rallies and flash crashes are occurring as I write this, with yet another record-breaking day of the Dow gaining 1,627 points on April 6th. Following the fastest bear market and worst first-quarter since ‘87, we have now closed out our best week on the Dow in 45 years on April 9th.
The full effects of this much machine trading is yet to be seen, especially as forward-looking markets must reconcile with double-digit unemployment and other economic uncertainties. While machines can change their allocation in the blink of an eye, many average Americans must grapple with the effects these swings may have on their livelihood.
Source: Wikipedia, List of largest daily changes in Dow Jones
March 2020: Fastest Bear Market in History
Last month holds the record for how quickly the market plummeted into a bear market at only 16 days starting on February 19th. The contrast is even more severe when calculating how quickly the March 2020 crash hit 30%
Source: Knox Ridley
Last month was not for the faint of heart. The bear market of March of 2020 took 19 days to drop 30% while all other black swan events took 55 days or longer. Meanwhile, the economic backdrop includes a health care crisis, high unemployment, canceled school years, and state mandates to “shelter in place.” Machines driving record gains last week are clearly not in a quarantine.
The Fed recently warned that the country could face an unemployment rate of 32%, or 47 million. This would exceed the Great Depression at 24.9%.
As we saw in 2008, massive unemployment forces the middle class to withdraw their 401Ks to pay bills.
This could cause major unintended consequences from the Federal Reserve policy that pushed retirement accounts into equity markets in order to keep up with inflation.
Despite evidence of negative consequences, rampant algorithmic trading in the financial markets has become accepted as the new norm.
However, this will be the first time that algorithmic trading could compound an economic recession as 401Ks have been squandered by the sheer speed of stock market machines.
This, of course, depends which way the wind blows next week and how machines react to news headlines with natural language processing (NLP).
Machines Behaving Badly: Faster than “Blink of an Eye”
High-frequency trading costs regular investors up to $5 billion per year, according to a recent study released in January of 2020. The practice of “latency arbitrage” involves arbitraging prices extracted by lower latencies. Better prices are then quickly bought by machines that can move quickly.
The FCA found the machines racing against one another is faster than “the blink of an eye” at 79 millionths of a second. The FCA study tracked 2.
2 billion transactions over 43 trading days and found 20% of trading volume was from latency arbitrages.
The FCA concluded that latency eliminating latency arbitrage would reduce the cost of trading by 17%. Six firms won the arbitrages 82% of the time.
In 2011, electronic inter-dealer broker ICAP had introduced a fifth decimal point to its EBS foreign exchange platform so that its currency pairs such as euro/dollar read as $1.24980, instead of the standard $1.2498.
The fifth decimal attracted high-frequency computers, which disrupted the flow of liquidity on the EBS platform. This upset the banks with slower technology as they could not execute large transactions when super-fast computers sliced them into smaller trades.
Notably, Deutsche Bank and Barclays had already offered tenth pricing to their customers.
In 2014, The Securities and Exchange Commission sanctioned a New York City based high frequency trading firm Athena Capital Research for placing a high number of aggressive, rapid-fire trades.
The trades occurred in the final two seconds of nearly every trading day during the six-month period with an intent to manipulate the closing prices of thousands of NASDAQ-listed stocks.
The Company had to pay a $1 million penalty to settle the SEC’s charges.
Tower Research Capital paid $67 million to settle spoofing charges. On thousands of occasions, between 2012 and 2013, the company manipulated the futures contracts on the Chicago Mercantile Exchange and the Chicago Board of Trade.
Evidence of Recent Algorithmic Damage
Over the last 10 years, commodity trading assets (CTAs) have collectively risen by about 36% to roughly $360 Billion.
Because they are hedge funds, they are ly leveraged anywhere between 2-5 times this amount, putting the total amount of assets anywhere between $1-2 trillion dollars.
These software driven funds tend to be crowded in the same trade together, which can make for violent swings.
Nearly a decade ago, there was a flash crash that occurred on May 6, 2010. This “flash crash” caused the Dow Jones to drop 998.
5 points (about 9%) within minutes, only to recover a large part of the crash later in the day.
According to the Commodity Futures Trading Commission (CFTC), high frequency trading “did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants.”
Flash crashes and flash rallies of 1000 points are now the new normal with sixteen occurring since March 1st. Four of these historical daily gains were above 9%. Trading curbs, known has circuit breakers, were hit four times last month.
Source: Wikipedia, List of Largest Daily Changes in the Dow Jones
Can’t Beat Them, Join ‘Em
During the Q4 2018 sell-off, Guy De Blonay, a fund manager at Jupiter Asset Management stated 80% of the stock market is controlled by machines. In 2017, JP Morgan stated that “fundamental discretionary traders” accounted for only 10 percent of stock trading volume.
Billionaire Steven A Cohen’s hedge fund had to focus more on quant trading in 2017 when it lost money in most of its traditional trading strategies in that year, while its quant investors made money. For example, Steven Cohen’s $12-billion hedge fund, Point 72 Asset Management, is moving about half of its portfolio managers to a “man plus machine” approach.
According to Wells Fargo, robots will replace 200,000 banking jobs over the next 10 years. Citigroup has formed a lab to cross-train traders and developers for machine learning and artificial intelligence. The programming language, Python, is especially in high demand at leading banks, such as JP Morgan and Goldman Sachs.
Daniel Pinto, JP Morgan’s Co-President, stated that investors may have to get used to big, sudden moves in the stock market due to fewer institutions pushing equities to attractive valuations while hedge funds reach unprecedented levels of employing computerized momentum-based strategies. The result will be “faster and deeper” corrections.
The problem with “faster and deeper” corrections is there is essentially no time for the average investor to adjust. Perhaps we will get a coronavirus vaccine or antiviral tomorrow, and business will go on as usual. Or, the opposite could happen, and things will get worse. One thing is certain: Until there is regulation, the machines will profit either way.
4 Ways Stock-Market Volatility Affects Every Business
August 24, 2015 11 min read
A lot of folks, on mornings when they wake up to find the Dow Jones Industrial Average off 1,000 points, breathe a sigh of relief that their fortunes, or prospects for a fortune, aren't tied to the whims of the stock market.
But they are tied. Bound, even. In fact, if you're breathing a sigh of relief now, you're ly going to be among the first to have the life choked your business.
Here's why: the stock market matters. A lot. We tend to make the mistake of viewing business as a local affair. We know our customers. We know our competitors. We know our employees.
But we often forget that the financial sphere — and the “Wall Street” too many people demonize nowadays actually binds them all together into a business ecosystem, that, the very air we breathe, is both vital and invisible to us.
And it doesn't matter if the averages closes higher on a day when they open down 1,000 points. It just matters that there was violence in the movement, volatility, uncertainty, mayhem.
Those swings affect you and your business in four key ways, and you probably don't even know it.
Ours is a consumer economy, built on spending. Wages are down, the labor-force participation rate is at historic lows, and immigration policies are making it difficult for the unskilled or semi-skilled worker to have job mobility. So how have we been able to show ecomomic growth? Credit. Americans take on debt to spend money.
We finance houses. We finance cars. We finance education. Hell, we even pay for groceries with credit cards. Using credit means you are borrowing money, transferring the entity to whom you owe the money. When you buy a car, the dealer gets paid from the bank, not from you. You, in turn, owe the bank, and pay over time, with interest.
It actually happens all throughout the buying process. Let's look backward, with the same car example. You borrowed to buy the car. You owe a bank money, but the dealer got paid.
The dealer bought from the manufacturer, often with a finance arrangement where the manufacturer was paid, but the dealer now owes the bank money. The manufacturer made that car ly with products it used bank financing to acquire the underlying parts, and the manufacturer owes the bank money.
Even at the grocery store, the supermarket generally gets short-term financing in acquiring the products on the shelves, the food producers get financing for the equipment used to process what's on your table and the farmers get financing (and government subsidies) to keep them operational for planting and harvesting.
Our entire economy runs off borrowed money, with the banks in the middle of almost every transaction, whether for a 30-year home mortgage, a 5-year car loan or a 30-day line of credit.
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That makes interest rates so important — and what makes the current market swoon so unsettling. Traditionally, the Federal Reserve lowers interest rates to stimulate the economy. That means it lowers what it charges banks to borrow to have access to the capital to lend out to folks. Rates are at zero. The Fed isn't going to go lower. If anything, it wants to start raising rates.
But looking at the Fed Funds rate doesn't matter to you that much because banks charge you an interest rate, whether you're a business or an individual, what the banks believe is your ability to pay in full. Just because a bank borrows at zero doesn't mean you won't pay 18 percent on a credit card, or 6 percent on a house, or 9 percent on an unsecured small-business loan.
It's this flexibility that banks have in setting rates that is directly affected by the market's fall. Your ability to pay, as assessed by the bank, is based partially on your past performance but also your market conditions. Falling markets create uncertainty. Uncertainty increases risk.
Risk raises what you're charged for interest. Suddenly, borrowing has become more expensive, raising the costs to manufacture and sell your product and lowering the attractiveness of the consumer to borrow to buy. All because the banks are watching the markets and dabbing sweat off their brows.
What they worry about, you need to worry about.
But what if you don't borrow? And what if all of your consumers pay cash? Or in Bitcoin? Or trade raccoon pelts?
Well, it is true that, if you have created a credit-free Elysium in your life, interest rates won't matter. But you still need to sell products, and that's where consumer confidence comes in.
People spend first on what they need, second on what they think they need but really just want, and lastly on the stuff they want but know they don't need. The last category is first to go at times in market uncertainty because people tend to cut back their spending.
Then comes the second category. Both are where most businesses make their money.
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Why would people hold back spending when the market is volatile? Because most people are invested in the stock market. We may not trade through online brokers everyday, but our futures are tied to the markets. If we have an IRA, a 401(k) or even a pension, those underlying assets float on the whims of the financial markets.
Swings there affect our personal wealth.
What we found during the financial crisis of 2008 was that our personal “worth” was too closely tied to home values and those were largely illiquid, unless of course we borrowed against that value (see Credit, above), which some of us couldn't do because we had borrowed way more than we should have in the first place.
While the response to our overreliance on home-mortgage credit was to lower interest rates to stimulate more borrowing (ibid.), the wisest of us began to save more and focus on areas in our personal lives savings and cash management.
We kept larger parts of our portfolios in cash, and only within the last few years dipped our toes in to the rising equities markets again. After all, anyone can sell a stock quickly.
It's a fairly liquid security, provided you the price and it isn't thinly traded.
True, retirement-savings investments are managed by mutual funds, but those funds invest in the stock market, mostly. Sure, there are different allocations, but the money is made in stocks.
What's more, the drop in the indexes belies the bloodbath many consumers' personal portfolios will suffer. In a fairly good market in 2014, 86 percent of active large-cap fund managers underperformed their benchmark indexes. And that wasn't a fluke. Almost 89 percent posted underperformance over the previous five years, with 82 percent underperforming over 10 years.
So, when consumers look at their portfolios, they see losses and translate that into less available money down the line. That means more saving, less spending and fewer people buying your products.
If you're in the middle of a funding round, expect it to be delayed, lowered or cancelled.
That goes for friends and family, who, all consumers, are nervous about their cash, to seed and other rounds, where venture capitalists might be worried about where they are coming up with their own money.
VCs to act Perseus before every market Kraken, but, in truth, they get just as nervous as you do. After all, with the exception of some angels, they're more often investing other people's money rather than their own.
They have to go out and raise money from wealthy individuals and fund managers who are just as nervous about parting with a buck in an uncertain environment. Many a VC might have Fortuna favet fortibus plastered on their office walls, but they got to where they are by following Durate et vosmet rebus servate secundis.
Even the deals that do come will be smaller. Private-company valuations generally follow public-company ones. It's the easiest — and most realistic — comparison to follow.
If tech companies on the Nasdaq suffer a Black Monday, it will be a Grey Tuesday for private companies seeking venture money.
The markets are demanding a valuation re-evaluation (and most smart VCs will welcome that, since it raises their potential returns at exit).
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If you think it's bad for an early-stage company to raise money, pity the later-stage one looking for an exit. In any period of high volatility for the stock markets, the first body bags are reserved for the IPO market.
Uncertainty kills initial public offerings because they are, by definition, the riskiest equity play an investor can make, since they don't have a track record as a stock.
When the Nasdaq Composite suffered its first major fall back in 2000, the IPO calendar went from being the most potent in history to drying up to nothing in a matter of weeks.
And those looking to exit through mergers and acquisitions shouldn't sit by their phones waiting for a suitor either. For a public company, a stock is a currency instrument.
You buy companies with cash or stock, or a combination of both. A drop in stock valuation is a devaluation in its most important currency with which to make an acquisition.
You might still get a deal, but it will come at a lower price because of the buyer's lack of flexibility in paying more.
Smart business owners and CEOs are probably saying to their staffs that they believe their companies aren't affected by this volatility and the best approach is to stay the course. Stiff upper lip, and all that. Privately, one hopes they are terrified — not in panic, but just scared enough to move from prudence to anxiety.
Why? Because how competitors act in these environments matters. If borrowing raises costs and lowers revenue, if consumers shy away from spending and if the ability to tap outside resources to keep the bills paid squeezes you, it squeezes just about everyone in your industry and you're fighting over a much smaller piece of cheese. It will get nasty.
You might have to cut prices and margins, which will attract customers but might make you lose money in the short term. You might end up in price wars with competitors, battles neither of you can afford. Better-capitalized competitors might lure you into these margin traps, knowing they can weather a war of attrition a lot better than you can.
Remember, you aren't just competing for customers. You're also competing for lenders and business partners.
And, as you fight for that smaller pie, you might find yourself getting squeezed by competition you hadn't even noticed before. The great irony of entrepreneurship is that it flourishes in bad markets and bad economic environments.
Despite all the feel-good rhetoric about how everyone should be an entrepreneur, long-term rates of business creation have been down for a few decades now. The reason? Well, part of it is that fewer businesses have failed, mostly because of government programs to keep bad ideas in circulation.
That lack of business dynamism hurts new-business creation.
Also, we forget that most businesses are created not just opportunity, but necessity. In times of high unemployment, people are more ly to be their own bosses, so they start companies to make money. It's the free market's safety net. As a result, the expansion of entitlement programs is one of the areas blamed for a slowdown in entrepreneurship.
Still, when companies are squeezed by competition and squeezed on margins, they often jettison staff. Those ex-workers, driven by entrepreneurial impulse and the necessity of maintaining a life for themselves, could take their knowledge, woo your customers and beat you at your own game.
If you don't believe that, you don't know your history (and Steve Wozniak and Steve Jobs would still be designing games for Atari).
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