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.

 

 

 

 

 

 

oil right now–the Iran situation

For almost a year I’ve owned domestic shale-related oil stocks, for several reasons:

–the dire condition of the oil market, oversupplied and with inventories overflowing, had pushed prices down to what I thought were unsustainable lows

–other than crude from large parts of the Middle East, shale oil is the cheapest to bring to the surface.  The big integrateds, in contrast, continue to face the consequences of their huge mistaken bet on the continuance of $100+ per barrel oil

–there was some chance that despite the sorry history of economic cartels (someone always sells more than his allotted quota) the major oil-producing countries, ex the US, would be able to hold output below the level of demand.  This would allow excess inventories to be worked off, creating the possibility of rising price

–the outperformance of the IT sector had raised its S&P 500 weighting to 25%, historically a high point for a single sector.  This suggested professional investors would be casting about for other places to invest new money.  Oil looked like a plausible alternative.

 

I’d been thinking that HES and WPX, the names I chose, wouldn’t necessarily be permanent fixtures in my portfolio.  But I thought I’d be safe at least until July because valuations are reasonable, news would generally be good and I was guessing that the possibility of a warm winter (bad for sales of home heating oil) would be too far in the future to become a market concern before Labor Day.

 

Iranian sanctions

Now comes the reimposition of Iranian sanctions by the US.

Here’s the problem I see:

the US imposed unilateral sanctions like this after the Iranian Revolution in 1979.  As far as oil production was concerned, they were totally ineffective.  Why?  Oil companies with access to Iranian crude simply redirected elsewhere supplies they had earmarked for US customers and replaced those barrels with non-Iranian output.  Since neither Europe nor Asia had agreed to the embargo, and were indifferent to where the oil came from, the embargo had no effect on the oil price.

I don’t see how the current situation is different.  This suggests to me that the seasonal peak for the oil price–and therefore for oil producers–could occur in the next week or so if trading algorithms get carried away, assuming it hasn’t already.

 

 

discount brokers and technical analysis

The stock market can be considered as the place where the financial characteristics of publicly traded companies meet the hopes and fears of potential equity investors.  Fundamental analysis addresses the former issue, technical analysis the latter.

In the US of the Roaring Twenties, technical analysis served both functions.  Depression era reforms that forced companies to release accurate and readily understandable financial statements had not yet been enacted.  So the trading activity of “insiders,” detected by carefully watching price and volume movements, was the best gauge one could get of how firms were actually doing.

Since that’s no longer the case, why do online brokers (Merrill Edge is the only exception I know of) provide such lame information on company fundamentals?

Several reasons, I think:

–brokers earn their revenue from trading, not from investment results.  (For what it’s worth, there’s a strong belief in the professional investment community that there’s an inverse correlation between the amount of trading a portfolio manager does and investment performance.)  So it makes some business sense that they should provide tools that make trades easy to do, with an old-style video game-like interface that makes it seem important and fun.

–a fundamental research effort is a headache.  It’s difficult to create and sustain.   It’s expensive, as well.  Arguably, offering proprietary research also exposes the broker to liability if the recommendations don’t pan out.  The user needs some accounting/economic background to understand what’s being said.  The broker who provides fundamental research has an obligation to consider whether a recommendation is suitable for a given client–opening another can of worms.  And, of course, an emphasis on fundamentals runs the risk of refocusing clients away from frequent trading, to the detriment of profits.

–discount brokers do offer a kind of fundamentals-based product through actively-managed mutual funds and ETFs, as well as through their sponsorship of networks of financial planners for whom they provide back office services.  Offering fundamental research might put brokers into competition with those planners.  And the fundamentally-based fund offerings carry a much higher price tag than DIY trading.

 

stop orders

The idea behind stop orders is to try to minimize losses in times of stock market turbulence.  In almost forty years of stock market investing, however, I’ve never used one.  In fact, I don’t know any professional trader or portfolio manager–or any amateur, for that matter–who has.

The details of what each kind of order does may differ a bit from broker to broker, so it’s important to read an exact definition on your brokerage website before you transact.  Generally speaking, here’s what they are:

what they are

Stop orders come in several flavors.

stop loss order.  The user selects a stop price below the current quote of a stock he owns.  If the stock declines to the stop price, a market sell order is entered.  (The order entered is a market order to ensure a sell transaction happens.  That might not be the case with a limit order.)

One important aspect of the stop loss is that trading after the stop has been triggered can be significantly below the stop level.

stop limit order.  Here the limit is typically placed above the current price, because the user wants to buy (to, for example, limit losses on a stock that has been sold short).  Once the stop is reached, a limit order for the stock at the stop price is placed.  That order will be filled before the stock can go higher.

One can also place a stop below the current price, combined with a limit sell order at the stop.  But this gives no guarantee the stock will be sold.

trailing stops.  I don’t get these at all, although I understand they’re popular with trading-oriented individuals.

Two characteristics:

—-the stop price and the limit price can be different.  Once the stock reaches the stop price, the limit order is placed.

For example. the stock is trading at $50 when the trailing stop is initiated.  The stop is at $45, triggering a limit order at $40. This protects the seller against a “flash crash”-like temporary dive, which he’s vulnerable to with a stop loss order.  The analogue on the buy side would be a stop at $55, triggering a limit order at $53.

—-the “trailing” part is that in the case of a sell order, the stop and limit are adjusted upward if the stock begins to rise (trailing behind along the same trajectory as the stock).  In the case of a buy order, the stop and limit trail along with the the stock if it begins to fall.  In either case, the stop and limit remain unchanged if the stock starts to move in an unfavorable direction.

An example (simplified a bit):  the stock is trading at $50.  You place a trailing stop sell order with the stop at $49 and the limit at $48.  The stock rises to $55.  The stop rises to $54 and the limit to $53. The stock then declines to $54.  This triggers the stop, which activates the sell order at a limit of $53 or better.  You sell at, say, $53.50.  If the stock’s initial move is to fall to $49, the limit order at $48 (or better) is placed.

 

my problem with stops

It isn’t that they take a bit of getting accustomed to.  It’s that the user makes relatively complex trading plans in anticipation of a market environment that may develop in a much different way than the plans have envisioned.  Their virtue, which is that they automate a trading plan in advance, is also their vice–that they can prevent you from applying human judgment based on the most current information at the time this may matter the most.

Maybe it’s just that I haven’t used these tools, but it seems to me that the door to unintended consequences is opened pretty wide by their employment.

order types: market vs. limit

market order vs. limit order

The two basic types of stock transaction orders are market and limit.

market order tells your broker to execute the transaction immediately at the best available price.  Your mindset should be that being sure the trade is done is more important than the price it is accomplished at.  You might, for example, be using the proceeds from a sale to pay a bill or to buy another stock the same day.

For highly liquid stocks, an individual’s market order should have little or no impact on trading.  So a market order should get you a price at or near the quote you see on your computer screen.  Microsoft, for instance, trades over 60,000 shares a minute.  So a 100-share, or even a 1,000-share order, is just a drop in the bucket.

In my experience, the only time a market order might be a worry is in the case of an illiquid stock where your order would be a significant portion of the day’s trading volume.  If so, a market order could get ugly.  When I ran a small institutional trading operation for a number of years, I thought that I could be no more than a quarter of daily trading volume.  Big institutions figure they can be no more than 10% without making a visible impact on prices.

 

limit order specifies a price that is the maximum you will pay to purchase or the minimum you will accept for a sale.  The broker is required to transact at the limit price if the opportunity presents itself.  He is permitted to transact for you at a more favorable price than the limit, but is not allowed to transact at a less favorable one.  So the trade may not get done on a given day.  Depending on your instructions, your unfilled order will either be cancelled at the end of the day or carried over to the next trading day.

Typically a limit is set at a better price than the current market.  I may enter a limit order, for example, to buy a stock at $68 when it’s trading at $70.

But a limit can also be set at a worse price for me than the current market and used as a quasi-market order.   If I want to buy a less-liquid stock, for example, I can enter a limit order at $70.50 when it’s now trading at $70.

 

Personally, I use limit orders a lot.  When I’m buying I will typically buy a third of my intended position at the market and set a limit at, say, 5% below the market for the second third.  If the stock hits that limit, I’ll set a lower limit for the final third.

I’ll scale up in a similar fashion when I’m selling.

 

Stops tomorrow.