Why Indexers Are Toast | The Mesh Report

Why Indexers Are Toast

John Thomas May 16, 2017 Comments Off on Why Indexers Are Toast

Hardly a day goes by without some market expert predicting that it’s only a matter of time before machines completely take over the stock market.

Humans are about to be tossed on the dustbin of history.

Recently, money management giant BlackRock, with a staggering $5.4 trillion in assets under management, announced that algorithms would take over a much larger share of the investment decision making process.

We are seeing this in the utter collapse of the Volatility Index (VIX), (VXX), to unheard of 23-year lows at single digit figures.

Exchange Traded Funds (ETFs) are adding fuel to the fire.

By moving capital out of single stocks and into baskets, you are also sucking the volatility, and the vitality out of the market.

This is true whether money is moving into the $237 billion S&P 500 (SPY), or the miniscule $1 billion Purefunds ICE Cyber Security ETF (HACK) which holds only 30 individual names.

The problem is being greatly exacerbated by the recent explosive growth of the ETF industry.

In the past five years, the total amount of capital committed to ETFs has doubled to more than $2.5 trillion, while the number of ETFs has soared to well over 2,000.

In fact, there is now more money committed to ETFs than to publicly listed individaul stocks!

While many individual investors say they are moving into ETFs to save on commissions and expenses, in fact, the opposite is true.

You just don’t see them.

They are buried away in wide dealing spreads and operating expenses buried deeply in prospectuses.

The net effect of the ETF industry is to greatly enhance Wall Street’s take from their brokerage business, i.e., there take from YOU.

Every wonder why the shares of the big banks are REALLY trading at new multiyear highs?

I hate to say this, but I’ve seen this movie before.

Whenever a strategy becomes popular, it carries with it the seeds of its own destruction.

The most famous case was the “Portfolio Insurance” of the 1980s, a proprietary formula sold to institutional investors that allegedly protected them by automatically selling in down markets.

Of course, once everyone was in the boat, the end result was the 1987 crash which saw the Dow Average plunge 25% in one day.

The net effect was to maximize everyone’s short positions at absolute market bottoms.

A lot of former portfolio managers started driving Yellow Cabs after that one!

I’ll give you another example.

Until 2007, every computer model in the financial industry said that real estate prices only went up.

Trillions of dollars of derivative securities were sold based on this assumption.

However, all of these models relied on only 50 years worth of data dating back to the immediate postwar era.

Hello subprime crisis!

If their data had gone back 70 years, it would have included the Great Depression.

The superior models would have added one extra proviso:  that real estate can collapse by 90% at any time, without warning, and then stay down for a decade.

The derivative securities based on THIS more accurate assumption would have been priced much, much more expensively.

And here is the basic problem.

As soon as money enters a strategy, it changes the behavior of that strategy.

The more money that enters, the more that strategy changes, to the point where it produces the opposite of the promised outcome.

Strategies that attract only $10 million market wide can make 50% a year returns or better.

But try and execute with $1 billion, and the identical strategies lose money.

This is why high frequency traders can’t grow beyond their current small size, even though they account for 70% of all trading.

I speak from experience.

During the 1980s, I used a strategy called “Japanese Equity Warrant Arbitrage” which generated a risk free return of 30% a year or more.

This was back when overnight Japanese yen interest rates were at 6%, and you could buy Japanese equity warrants at parity with 5:1 leverage (5 X 6 = 30).

When there are only a tiny handful of us trading these securities, we all made fortunes. Every other East End London kid was driving a new Ferrari (yes, David, that’s you!).

At its peak, the strategy probably employed 10,000 people to execute and clear in London, Tokyo, and New York.

However, once the Japanese stock market crash began in earnest, liquidity in the necessary instruments vaporized, and the strategy became a huge loser.

The entire business shut down within two years. Enter several thousand new Yellow Cab drivers.

All of this means that the current indexing fad is setting up for a giant fall.

Except that this time, many managers are going to have to become Uber drivers instead.

Computers are great at purely quantitative analysis based on historical data.

Throw emotion in there anywhere, and the quants are toast.

And at the end of the day, markets are made up of highly emotional human beings, who want to get rich, brag to their friends, and argue with their spouses.

In fact, the demise has already started.

Look no further than investment performance so far in 2017.

The SPY is up a scant 7.14%.

Not much to write home about, but it’s better than a poke in the eye with a sharp stick.

Apple (AAPL), on the other hand, the most widely owned stock in the world, is up an eye popping 50%.

If you DON’T own Apple, you basically don’t HAVE any performance to report for 2017.

I’ll tell you my conclusion from all of this.

Use a combination of algorithms AND personal judgment and you will come out a winner, as I do. It also helps to have 50 years of trading experience.

You have to know when to tell your algorithm a firm “NO”.

While your algo may be telling you to “BUY” ahead of a monthly Nonfarm Payroll Report or a presidential election, you may not sleep at night if you do so.

This is how I have been able to triple my own trading performance since 2015, taking my 2017 year-to-date to an enviable 23%.

It’s not as good as being 100% invested in Apple.

But it beats the pants off of any passive index all day long.

Want to know what John Thomas REALLY thinks?

Click here for a free global strategy webinar giving John’s 2017 outlook on stocks, bonds, foreign exchange, commodities, energy, precious metals, and real estate, and YOU TOO can make 38% a year!

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