Podcast: The revenge of the machines

About the author:

Michael Knox
Author name:
By Michael Knox
Job title:
Chief Economist and Director of Strategy
Date posted:
13 March 2020, 12:40 PM

The market is being sold down by machine trading programs focused on momentum. This fall will be brought to an end by a surge in Fed Liquidity.

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I think what we are suffering from is the revenge of the machines. When we look at trading in the US, it’s not done by individual people anymore. It’s done by powerful programs which are run by large investment funds. If you look at how those programs are set up, some of the components are very similar to the components in our stock market model. You have things like earnings, you have things like the yield on comparative investments.

In addition to that, what you have is the stochastic (what’s left over). How the stochastic is modelled within these trading programs is by momentum. These machines are designed to make that momentum trade first.

We are in a situation in which what’s driving markets really has nothing to do with market fundamentals, it has nothing to do with earnings, it has nothing to do with bond yields. It’s driven by an extraneous event. The sort of extraneous event that happens once every 50 to 100 years. In that circumstance, what we’ve seen is machine trading systems competing with each other to be the first in momentum; to take the sell decision first.

Where that’s got us to is yesterday our market (I’ve said before is more efficient than the US market) closed 977 points below fair value in terms of our model. The previous most overvalued the market has been, relative to our model in the very long period that we’ve been running, is about 953 points below fair value. That was during the financial crisis of 2008.

The US S&P500 fair value is 2,840 and now the market is 460 points below that. The problem that I see is that the peak in the market (in terms of points) was probably 379 points more than fair value. What we see is that there’s little more downside in the Australian and US markets to get to the maximum levels of undervaluation that have been experienced using these models.

When does that stop? It doesn’t stop because robot trading machines get smarter. It stops because the amount of liquidity in the market overwhelms the ability of trading machines to sell. What we see is that the Federal Reserve is stepping up to that challenge saying that they will provide $US1.5 trillion dollars. This is equal to the size of the entire Australian GDP. This will provide additional liquidity in the US market, absorb volatility and will stop the market falling.

The Fed has now cut the Fed Funds rate to a maximum of 25 basis points or 0.25%. The Fed has resumed Quantitative Easing by announcing intended purchases of $US500 billion of US Treasury bonds and $US200 billion of Mortgage Backed Securities.

What the Fed is doing is trying to catch the falling knife. But they’re the only organisation that has so much money that they can stop this destruction of asset value. I believe, as always, like in previous events, they’ll be successful in doing that.

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