The party may be over for automated trend-following trading strategies on Wall Street. As a recent report by Bloomberg highlights, the once legendarily profitable investment systems run on computers by hedge fund managers have lost their edge. Although still dominating a large share of capital compared to human traders, the machines are not as invulnerable as they once were. Wild volatility in the Dow Jones and other major US stock market indices makes that abundantly clear.
Smooth economic cycles are one thing, but unnatural monetary policy from the Federal Reserve – alongside market-shaking tweets from Donald Trump – are something else altogether. As the chart below demonstrates, the bulls are back, but will it last?
For the Dow Jones Industrial Average, volatility is becoming the new normal. | Source: Yahoo Finance
Why Did Trend-Following Strategies Get so Popular?
The answer to this question is self-evident but has a few prongs. Firstly, in trading, innovation is as important as it is in any business. If you can do something that no one else does, then not only do you attract a lot of marketing attention, but you can also create a sizeable trading edge. This advantage manifested itself when trend-following first became popular in the 1970s and 1980s, and a lack of competition allowed them to dominate the less volatile stock market climate.
It has since become apparent that even these early pioneers were flawed in their assumptions, and hence people are now fading their approach amid an influx of professional traders into the markets. Technical improvements set the stage for the high-frequency trading arms race, where computers would look for tiny price inefficiency, and saw hedge funds doing things as crazy as moving next door to the stock exchanges to get a micro-second edge in their price feed.
Predatory Algorithms Stalk Price Breakouts
Predatory systems stalk the stock market like wolves looking for weak hands. | Source: Pixabay
The automatic trend-following strategies we are talking about today are slower money than this, but they work on similar principles. Does anyone remember the ridiculous rally the Dow embarked on during the final days of 2018? This was not human greed, but rather cold-hearted machine singlemindedness that priced in Trump’s handouts.
If you see the Dow or S&P 500 falling “unnaturally” quickly, then you can probably blame the machines too. When bots pile in on breakouts, “predatory algos” stalk the markets looking to fade them, just like we began to see human traders do in the 1990s. If the Dow Jones breaks out even further above 26,000 and market momentum fades, the predators will try and bash it back down again immediately as the buyers run out of steam.
We also have the issue that news travels faster than ever. This news can then be incorporated faster by computers than humans ever could by hand. Trading bots exist which scan central bank press releases at lightning speed, allowing them to react more quickly. Markets frequently spike wildly, as sometimes the bots disagree and find additional keywords that change their mind. People have even come up with systems that short stocks based on the content of Donald Trump’s tweets.
Wall Street Hedge Funds Have Grown Bloated and Complacent
Professional traders always like to stress the importance of standing alone against the crowd. It would seem that the once-privileged few who could afford the millions of dollars of computer systems to run sophisticated algorithms have seen competition erode their edge. Every single trading strategy devised has market conditions where it is not as successful as it might be. These trend followers were essentially just uber-bulls. Hedge Fund sales teams were accumulating incredible assets as they took on more risk and hence looked smarter. As the Federal Reserve went all-out to lift markets, volatility dipped.
The most intelligent guy in the room was the one that bought highs the most aggressively. The fact a fund could say it was because of his genius new computer-based strategy didn’t hurt the sales efforts, with the added benefit they could now hire programmers to maintain the systems while the managers spent more time on the golf course wooing new clients. If it sounds like I’m criticizing these people that is not my intention. I merely follow the “Market Wizards” inspired premise that risk/return is the accurate indicator of trading skill.
With Federal Reserve policy less clear over the next few years, confidence remains wobbly in equity markets. Trend-following loves certainty. If there is one thing that Trump, Brexit, and other nationalist movements have created, then its uncertainty. Buy high, sell higher bulls got lazy, and they are now paying the penalty.
Age of the Trump Tweet Gives New Hope to Human Traders
Estimates suggest humans make just under 10% of trades in markets. Consequently, having a little human perspective might give discerning hedge funds an edge. The trading arms race was unsustainable and didn’t improve market efficiency. If anything, it created the phenomenon of the “flash crash” such as the one we saw recently in Bitcoin.
So if you are someone who wants to dive into trading, remember: the market is moving on a flawed premise. A less binary mindset might help you cut the losses quicker and be more careful with your profits.
Trend following is not archaic; it is timeless, but it must be applied intelligently with a holistic view of sentiment and positioning. Even then, the best systems might only win one-third of the time. You can make a fortune winning 33% of the time, but most aren’t selective enough.
In the era of the Trump Tweet, it takes one hell of a programmer to trade systematically and beat the market. It looks like at least some of these asset-accumulators have been found out.
Disclaimer: The views expressed in the article are solely those of the author and do not represent those of, nor should they be attributed to, CCN.