The Computers Are in Charge of Investment Decisions

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As the market marches relentlessly higher, here’s a clue as to why, from the Financial Times:

The quantitative hedge fund industry is on the brink of surpassing $1tn of assets under management this year after breakneck growth from rising interest in more systematic, computer-powered investment strategies.

The amount of money managed by quant hedge funds tracked by HFR, a data provider, rose to more than $940bn by the end of October 2017 — nearly double the level of 2010 — and flows have continued to be strong in the fourth quarter, according to hedge fund executives.

An explosion of interest in automated, algorithmic investment approaches, ranging from the simple to high-octane strategies powered by artificial intelligence, has driven the surge. Even many traditional hedge funds are now hiring data scientists and programmers to reshape themselves into quants.

It’s going to be a long time before computers are smarter than humans. But when it comes to investing, broadly speaking, computers are already smarter than humans.

That’s because computers don’t have emotions, or ego. And it’s these two factors that get us into trouble time and time again.

Since the 2008 credit bust, hedge funds have had a tough time of it. Especially the ‘macro-focused’ funds. These are the guys who make bets based on big picture calls.

But with the post-2008 global economy being a central bank engineered one, macro hedge funds have found it very hard to make money. Central banks have squeezed the life (and volatility) out of markets.

Hedge funds in the traditional sense require volatility to thrive. That’s because they take some positions to offset others…they ‘hedge’. They take advantage of market volatility.

They also tend to do better during bear markets. That’s because of their ability to short sell. That is, profit from share price declines.

A good example is Odey Asset Management, a bearish UK macro-based hedge fund headed by Crispin Odey. It lost 50% in 2016 and 20% in 2017.

That’s the result of wrong decisions made by a human, based on opinion. And it’s happening right across the hedge fund world.

The computers, on the other hand, are simply following the trend. That’s attracting capital flows, which reinforces the trend and makes the computers look even smarter.

Throw in the rise and rise of passive ETF index investing (whereby capital blindly pours into the market) and you have very powerful forces pushing this market relentlessly higher. 

How long it can go on is anyone’s guess. The general rule of thumb though is that markets can continue to act in absurd ways for much longer than you expect. Or, in the words of Lord Keynes, markets can stay irrational for longer than you can stay solvent.

Crispin Odey must surely be worried about those prophetic words. He may think he’s right. And he may be eventually be proved right. But right now he’s wrong. Horribly wrong.

The same goes for loads of other hedge funds struggling to come to grips with a market that won’t seem to go down. They’re struggling because they can’t ‘see’ the rationale for it.

But computers don’t worry about rationale. They just do what they’re programmed to do, which eventually exacerbates the prevailing trends.

But don’t forget, humans program the computers. Human nature is behind all market cycles. It’s just that this cycle is being helped along by the desire to make gains based on unemotional computer generated decisions. People falsely believe these decisions are better and less risky.

They’re not. They only seem that way for now…

Bitcoin bust?

This is not the first time I’ve mentioned the possibility of a Bitcoin bust. Yesterday I mentioned the concept of ‘distribution’ taking place after a stock, asset, or index had enjoyed a strong bull market or bubble. That is, as early investors sell out to the latecomers (distribute their stock) volatility increases and a top forms.

Is that happening now with Bitcoin? Have a look at the chart below…

Bitcoin / US Dollar - XBTUSD FX Daily | 10-01-2018

Source: Optuma
[Click to enlarge]

Note the parabolic surge from late November to the December high. That represents a gain of nearly 140%. Then the big correction, followed by the rebound.

But the rebound is struggling to get back to the old highs. In the absence of quick additional gains, there is a risk that the short term speculators will want to get out.

This is just a guess, but it looks to me like distribution is taking place in Bitcoin. That is, early investors are selling to the latecomers, causing price volatility around the peaks. As the belief in further gains start to diminish, the latecomers will want out too. That will cause further price falls.

Let’s see what happens. We may get another rally to test the December high around US$19,000. If that rally fails to produce a new high, you’ll likely see some very sharp falls.

Greg Canavan,
Editor, Crisis & Opportunity

About Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need…

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