Will Quants Blow Up the Markets?

By Robert Wenzel

Three things are required for quants to blow-up the markets, big money, leveraged money and data that takes a walk from its empirical trend.

Big money is back in the hands of quants and it is leveraged. Most market trends remain in sync but that will not always be the case.

That's the danger.

As the economist G.L.S. Sahckle wrote:

It will be a kaleidic society, interspersing its moments or intervals of order assurance and beauty with sudden disintegration and a cascade into a new pattern.

A business cycle downturn can cause markets to go kaleidoscopic and cause the cascade of new data patterns to emerge.

But it is entirely possible that data can go very long tail for other reasons and cause government officials to react in panicked fashion and make things worse.

Shackle warned:

[A] loss of direction, in the economic aspect of affairs, might consist in a catastrophic slump or an uncontrollable inflation and the destruction of the currency and the society's confidence.

I bring these cheery thoughts to the forefront because of a new report from the Financial Times that carries the subtitle: Nearly 10 years after its nadir, quantitative investing is again the hot trend in finance.

The report first recounts what surely can be called the 2007 turning of the kaleidoscope:

[O]n August 6 2007, everything unravelled. As soon as US markets started trading, the previously wildly successful automated investment algorithms coded by the QIS brainiacs went horribly awry, and losses mounted at a frightening pace.

What became known as the “quant quake” subsided in a week and was largely contained within the computer-powered investment industry. It was soon overshadowed by the global financial crisis. But it scarred a generation of financial scientists on Wall Street. Even Renaissance Technologies, the legendary hedge fund co-founded by cold war codebreaker James Simons, suffered painful losses, and it nearly obliterated Goldman’s QIS.

 But the shock of 2007 has worn off. FT again (my highlight):

Nearly a decade later, quantitative investing is once again the hottest trend in finance. Computer-driven hedge funds have just notched up their eighth straight year of client inflows, doubling their assets from 2009 to $918bn, according to Hedge Fund Research. Even this understates the interest, as many traditional hedge funds and big mutual fund managers are all trying to blend more quantitative techniques with their traditional approaches.

And smart money people are worried:

The explosive growth of algorithmic investing — whether high-frequency traders, next-generation exchange traded funds or artificial intelligence-powered hedge funds — has transformed the markets. Some analysts fear that another 2007-style meltdown would be more severe due to the proliferation of quant strategies.

“It’s the biggest worry I have,” says Richard Bookstaber, a former risk manager at Morgan Stanley and Moore Capital, now a research principal at the US Treasury’s Office of Financial Research. “What is going on now is not just the growth of quant hedge funds, like before the crisis. Now it’s system-wide across the investment world. In 2007 it was localised because no one else was pursuing these strategies. Now everyone is.”

For all practical purposes, the Federal Reserve has been pumping money full out since the 2008 financial crisis, timing is uncertain, but, at some point, money growth will slow and knock the legs out from under the current quant trading patterns (and the rest of the economy).

But it may not even take a serious Fed tightening of money growth. There are plenty of unknowns, especially surrounding Trump economic policy, that could twist the kaleidoscope. It is very possible that a Trump macro policy step, perhaps in the area of international trade or massive military spending, would be enough to distort key economic or dollar exchange correlations enough to send the quants into liquidation mode.

Bottom line: The government creates a very unstable economic environment and quants trade without taking this long term instability into account. It is difficult to do so.They get hypnotized by 10 years of temporary stability and think the stability will go on into infinity.

Remember, that's exactly what Gary Chropuvka, fromerly of the Goldman Sachs Quantitative Investment Strategies division, said happened going into 2007:

All this worked academically, and for a long time it worked in practice, and then all of a sudden you have this horrible event.It was the most humbling experience of our lives.

It will occur again. Government meddling in the economy is an extremely destabilizing force over time. It is the long term enemy of stability and, therefore, also of quants.

Robert Wenzel is Editor & Publisher of  EconomicPolicyJournal.com and Target Liberty. He also writes EPJ Daily Alert and is author of The Fed Flunks: My Speech at the New York Federal Reserve Bank. Follow him on twitter:@wenzeleconomics and on LinkedIn. The Robert Wenzel podcast is on  iphone and stitcher.