The US stock market just experienced one of its more impressive down days ever, with the S&P 500 losing 783 points out of 27,782. This was not the worst percentage drop ever but it vied for the most points of the S&P 500 lost in one day. There are lots of valid concerns about the longevity of the current bull market such as an uncertain trade war, rising interest rates, and tepid earnings. However, much of the blame for the one-day drop in the market is being placed on trading algorithms that control roughly 80% of daily stock trading. That being the case, how does algorithmic trading affect your investments?
CNBC writes about machines that control 80% of the US stock market.
“Eighty percent of daily volume in the U.S. is done by machines, so what you get is a lack of focus on earnings, a lack of focus on outlooks and you just get short-term movements based on very specific data that is released every day and that creates noise,” Guy De Blonay, fund manager at Jupiter Asset Management, told CNBC’s “Squawk Box Europe.”
The daily volume of algo trading can change according to volatility. But over the last few years its impact has become more visible. In 2017, J.P. Morgan said that “fundamental discretionary traders” accounted for only 10 percent of trading volume in stocks. This is when traders look at companies’ performance and outlook before deciding whether to buy or sell the shares.
This is the shape of the modern stock-investing world. So, you cannot change it but you can invest in such a way that algorithmic trading does not hurt your investments or even helps them!
Yesterday’s S&P 500 freefall was 782 points out of 27,782. That is a 2.8% decrease in value across the S&P 500. But, going back to 1929 there have been twenty days with larger percentage losses, including October 19, 1987, with a 22.61% loss in the Dow Jones Industrial Average.
Although there were typically good reasons for many of the down days of the Dow or S&P 500, the immediate market movements in recent times often came from computer programs that were designed to sniff out early cues and make trades before the market fell. And, as more programs sold, the other programs followed suit, and in a matter of hours, minutes, and even seconds, the market fell more than the fundamental or intrinsic value of any of these stocks would have predicted.
How does algorithmic trading affect your investments in these cases? It depends on how you react to the market changes.
Using Intrinsic Value as an Investment Guide
On this site we so often write about the use of intrinsic stock value as a guide to long term investing. How does that advice square with the seeming control of the stock market by machines that make 80% of daily trades? First of all, consider what CNBC writes about intrinsic stock value and how Warren Buffett uses it to choose investments.
Buffett’s long-term associate and the Vice-Chairman of Berkshire-Hathaway is Charlie Munger. He discussed how hard it can be to put the intrinsic value approach into practice and how exceedingly selective they are in making their choices.
Munger went on to deflate the hopes of any investor who is confident enough to think they have valuation mastered. When it comes to valuation of companies, even he and Buffett draw a blank most of the time. “We throw almost all decisions into the too hard pile, and we just sift for a few decisions that we can make that are easy. And that’s a comparative process. And if you’re looking for an ability to correctly value all investments at all times, we can’t help you.”
In short, much of the success of Berkshire-Hathaway comes from avoiding the vast majority of investments as “too difficult to call” and directing their attention to those investments where determining future cash flow is easier. This approach has proven successful in their hands and is the “gold standard” for how the intrinsic value approach should work.
Long-term Versus Short-term Investing
If you are going to compete with the trading algorithms that control most of the daily stock trading volume, you need to be very good and insightful or just plain lucky. On the short term basis, these programs are faster than you will ever be. However, they really do follow a herd mentality in both US and global investing. As such, there is always the possibility of picking up bargains the day after the algorithms take the market down. In fact, we often see an up day in the market immediately after a significant market downturn. But, this approach means that you are always second guessing a bunch of computer trading programs and how they analyze stocks instead of analyzing the stocks yourself.
Buffett and Munger and many others have proven that a patiently-applied intrinsic value approach makes money over the long term.
This certainly looks like, and is, a significant price decline in one day. However, what if we look at the last twelve months?
Now we can see that in the last year the S&P 500 is up about 70 points, after flirting with a much higher range before correcting. But, if we look at picking an investment to hold for five years, as we did recently, here is the S&P 500 going back to December of 2013.
Here we see that the S&P 500 has increased four-fold since five years ago despite a fair amount of up and down volatility. Anyone who was a passive investor and just put his or her money in an ETF that tracked the S&P 500 over this time would have done well and not experienced any pain from fighting the trading algorithms that control Wall Street daily trading. In fact, one could have routinely bought the day after an algorithm-driven downturn and picked up bargains along the way.
How Does Algorithmic Trading Affect Your Investments?
The “bottom line” is that day trading and short-term stock picking are different games than long term value investing. The other “bottom line” is that when investing for the long term is it wise to limit yourself to stocks and other investments where you understand the business plan and where you can be assured that the investment will generate reliable returns year after year. This is why a stock like Coca Cola is always a favorite of investors like Buffett and why many long-investors avoid tech stocks because of the risk of a new invention making a current technology obsolete and reducing a tech all-star to a penny stock in a matter of months.