machines vs. humans

…a financial Industrial Revolution?

I remember reading, years and years ago, an analysis of changes in the nature of work that happened during the Industrial Revolution.  The general idea is that, say, candlesticks had been made as one-of-a-kind items, out of precious materials and ornate decoration, worked for months by an artisan who had spent years learning how to do this.  Yes, the end product was useful, but it was also very expensive, meant for a niche audience, and acted as a sign of the owners’ superior wealth, taste and privilege.  In contrast, the “new” candlestick was made, fast and cheap, out of ordinary stuff, by a guy who knew how to operate a machine.

Today we find it hard to imagine the possible appeal of most pre-IR objects.  Yet they were once the norm.

 

The macro/microeconomic research-based stock market investment reports of the kind I used to create were made by people, like me, who served long apprenticeships under masters of the craft.  The work tended to only start to approach minimum standards after the author had, say, five years of practical experience in an investment management firm.  Buy-side portfolio managers like me also used the voluminous output of internal or brokerage house analysts who spent their careers studying a specific industry group.

By 2019, most of the experienced buy- and sell-siders have either retired or been laid off,  and have been replaced in many cases either by computer-controlled index-tracking products or by algorithms.  The main forces in today’s daily stock market trading have become machines, some programmed to carry out the wacky theories of the academic world, others to react to signals from the patterns of trading itself (i.e., technical analysis) or to news stories (typically written by reporters trained mostly as writers) or to extrapolate from the patterns of past business cycles.

progress or free-riding?

Are the research reports of a decade or two ago analogous to the candlesticks of the Pre-IR era?  Are algorithms like early industrial machines?  Are they a better and cheaper, although different, way of dealing with financial markets than having a very expensive group of human craftsmen?  Does this mean those who decry algorithms are simply Upper East Side-dwelling Luddites?

I don’t know about “simply.”  My feeling is that algorithms are here to stay.  And my experience as an investor is that it’s very dangerous to think that just because you don’t like or understand something that it serves no purpose.

Still, my suspicion is that as it stands now, there’s a healthy dose of free-riding to algorithmic trading.  In other words,  it looks to me as if some algorithms rely on reading the signals of human professional investors as they move in and out of stocks in response to their research findings.  As those humans are displaced by machines, however, those signals will disappear–implying algorithms will have to evolve if their raw material is to be something other than random noise.

 

 

 

 

 

 

Apple, industrial activity, the jobs report

the Employment Situation

The Bureau of Labor Statistics made its monthly Employment Situation report this morning:  +312,000 new jobs, +58,000 upward revision to the prior two months’ data, annual wage gains of an inflation-beating +3.2%.  Yes, it’s just one month and, yes, the margin of error is +/- 100,000 jobs, but it’s still a very strong report, indicating a robust domestic economy.

 

Despite this show of employment strength, the stock market has been on a sharply downward path since late September.  What is the market thinking/anticipating?

–the 10-year Treasury, which was yielding 3.22% in late September now yields 2.56%;  the middle of the yield curve is now mildly inverted.  This suggests bond buyers believe a marked slowdown in economic activity in the US is in the offing–one that will force the Fed to soon begin to lower short-term interest rates again.  Why would that be?

–the Trump tariff war with the rest of the world seems to be affecting publicly traded companies much more negatively than one might have imagined

–only about half the earnings of the S&P 500 come from the US.  Both the EU, dealing with Brexit and Italy, and China are slowing down

–some pundits argue from the bond market situation that the Fed is the problem, having –they think–raised short-term interest rates too far.

 

Two pieces of data from yesterday seem, on the surface at least, to reinforce the sharp slowdown narrative:  Apple (AAPL) and business investment activity.

AAPL

–AAPL announced Wednesday night that its December quarter revenues would be about 8% below the midpoint of the guidance it gave in October.  What makes this significant, besides AAPL’s size, is that the company rarely misses its quarterly estimates.

Two reasons given:  falloff in sales in “greater China” and slower than expected takeup of the newest generation of iPhones by existing customers (the smartphone market is completely saturated–there are no more “new” customers).  Neither reason is clearly a sign of broad-based consumer distress, however.

AAPL recently said it would no longer reveal unit sales of its smartphones, a decision I take to mean it intends to make revenue gains through price increases rather than unit volume gains.  Is the slowdown in replacement demand caused by economic weakness or AAPL pricing new phones so high that other, cheaper phones are suddenly more attractive?

Also, the latest issue of Foreign Affairs reports that popular sentiment in China has turned sharply against the US in the past half year or so as Washington initiated its tariff war.  Maybe, in addition to higher prices, flaunting the newest iPhone is no longer as culturally acceptable in China (think:  the century of humiliation), as having a home-grown product.

ISM

–the Institute for Supply Management issued its monthly report on US manufacturing activity yesterday.  It shows a continuing slowdown in industrial activity.  The reason most often cited in survey respondents’ comments is the administration’s tariff war.  Manufacturers are, predictably, shifting production out of the US to avoid import tariffs on raw materials and export tariffs on finished goods.

It’s important to remember, too, that manufacturing is not the key to US economic strength that it was a generation or two ago.  Spending on software is the largest investment item for most service companies.  Yes, this activity is also being shifted abroad as the administration makes it more difficult for foreign-born computer scientists to work in the US.   But I don’t think the ISP report is “new” news, so I’m not sure why it had such a negative effect on the market yesterday.

my take

In the short term, figuring out the root cause of the worries about the US economy is probably less important than trying to gauge how far along in the selling we are now.  Better to figure out when the storm will be over than debate the direction of the wind.  My guess–and it may be more of a hope–is that we made the lows on Christmas Eve when stocks broke decisively through the February 2018 lows.

Personally, I think the ultimate problem is Washington and the tariffs, not the Fed.  I’m all for protecting US intellectual property, but the levies on, say, steel and aluminum seem so arbitrary and generally harmful.  In a way, it would be a lot better if the Fed is the issue, since then the problem would be a familiar one, the market situation clearer and the fix relatively easy.

 

 

 

 

 

stock market issues for 2019

I see four main issues, which–now that I’m on semester break–I’m planning to write about over the next few days.  They are:

machines vs. humans.  This is the question of increased short-term volatility.  How do we cope with the apparently mad dashes in and out of the market by trading robots using, by historical standards, half-baked trading algorithms?

 

decelerating earnings growth.  EPS growth in 2018 for publicly traded companies was around +20%.  Increases for 2019 will likely come in at +8% – +10%.  This kind of sharp falloff is normally a bad sign for stock prices.  In the current case, however, the 2018 EPS surge is only in after-tax earnings and is due mostly to the one-time decrease in the Federal corporate tax rate from 35% to 21% that went into effect last year.   Pre-tax earnings grew at a much more sedate rate of around 10%, I think.  While the 2019 situation isn’t wildly positive, it would seem to me to imply a flattish market where the investor’s job is to identify areas of potential strength to buy and areas of potential weakness to avoid.

But is this the way algorithms will operate?

 

the business cycle and interest rates.  Typically, the Fed raises short-term rates when it perceives the economy is overheating.  Higher rates make bonds less attractive.  They make other financial instruments, like stocks, less attractive, too.  But the negative effect of higher rates is offset by surging earnings growth.  Is +10% enough to do the job in 2019?

 

–tariffs.  (A side note first:  it seems to me the Trump administration argument that it can usurp Congress’s power to set trade policy because everything economic is a matter of national security is ludicrous.  Not a peep from Congress, though.  To me, this implies that Mr. Trump is simply the spokesmodel for policies the forces in Congress want enacted but don’t want to be held responsible for.)

Tariffs have, at best, a checkered history.  They invite retaliation.  They have unforeseen/ unintended negative effects: Apple’s preannouncement of weaker than expected results in its current quarter may only be the first.   In addition, the rapid and seemingly arbitrary way tariffs have been enacted in the US has already given both domestic and foreign corporates pause about expanding operations here.  One thing is certain, though –tariffs slow economic growth.  The question is by how much and for how long.

 

the independence of the Federal Reserve.  By conventional measures, there’s still too much money sloshing around in the US.  So there’s every reason for the Fed to continue to shrink its bloated balance sheet and to slowly raise short-term interest rates (the specter of Japan’s three decades of stagnation–resulting in large measure from saveral bouts of premature policy tightening–continues to be a cautionary tale against moving too quickly).  Because of this, Mr. Trump’s musing about firing Jerome Powell has a distinctly Nixonian ring to it, conjuring up echoes of the runaway inflation and currency collapse in the US of the 1970s.  From a stock market point of view, threatening the Fed may be the single most damaging thing Mr. Trump has done so far.

 

More details over the next few days.