Friday, August 28, 2015

Be Careful What You Wish For

Back in the 1990's, Legg Mason's Bill Miller was synonymous with investing excellence. He ran the Legg Mason Value Trust mutual fund, and his after-fee returns beat the S&P 500 index for 15 consecutive years from 1991 through 2005. He was often mentioned in the same breath as Warren Buffett where money making prowess is concerned. Miller's investing style was utilizing a concentrated portfolio which was in vogue at the time, and he made outsized bets on young technology companies like America Online. You can't argue with his success.

Back when Bill Miller was front page news, I distinctly remember an interview with him, and he was asked what books he was reading to compliment his investing process. He replied he was very much influenced by horse handicapping and betting books. This was before the advent of High Frequency Trading and the proliferation of Quant Funds that are popular in today's investing world. I don't know what Mr. Miller's investing style or track record is in the environment of proprietary trading algorithms, but he may have changed with the times.

Last week I read a book, Smart Sports Betting by Matt Rudinitsky that stated the sports betting market is very much like the stock market. Below are quotes by the author on the parallels of the two, plus my own commentary:

  • It incorporates everything that is public knowledge. (Just like the Web bots that scour the Internet for press releases that report investing information such as earnings statistics. By the time the retail investor gets wind of the information, deep-pocket investors have already taken advantage of the price/action.)
  • It incorporates the thoughts of all professional bettors, because their money has flown into the market and given oddsmakers information on who they like. (Sounds a lot like the options market. Industry insiders know where the hot money is flowing.)
  • It incorporates the thoughts of many ridiculously complicated algorithms that professional bettors have backed up with lots of money. (This parallels with quant hedge funds.)

Statements like this are why I have almost given up investing in individual securities, and have migrated to passive investing in index funds like iShares Core S&P 500 (IVV). All is known...except when you get a flash crash like we did on Monday when the DOW dropped close to 1,100 points at the open. Although we've regained a lot of those losses after a two day rally, the sensory overloading drop spooked both retail and institutional investors.

We haven't experienced a flash crash, or whatever you want to call it, in five years. With the high frequency trading networks and quant funds commandeering the exchanges, selling begets more selling. A vicious cycle as trading triggers kicked in as each technical level was breached. If you didn't have limit orders in place before the market opened on Monday, you were out of luck for a brief period of time. Many brokerage houses shut down for the first fifteen minutes of trading from the overwhelming volume and price depreciation in both equities and ETF's. You would not have ben able to log into your brokerage accounts in some instances.

One piece of carnage on Monday was the drop in the iShares Core S&P 500 ETF, which was down almost 25% in the first few minutes of trading. This did not correlate with the overall decrease in the S&P 500. The decrease in the iShares Core S&P 500 ETF was much more severe. Although the price/action balanced out after about ten minutes, if you sold your shares at market price, you got fleeced. Although high frequency trading makes the markets much more liquid, it is times like these that it is important to always use limit orders.

Nobody really knows what caused the violent sell-off, but speculation is that it was the implosion of the Chinese markets, and the continuing decrease in the price of oil. An infusion of cash by the People's Republic of China in their native exchanges, and a short squeeze in oil have helped boost the overall indexes the past two days. In fact, at this juncture, we're up for the week, but down 6% for the month.

My personal belief is that the correction is healthy for the markets. I had limit orders in and bought a stock and an index ETF early Monday morning - Twitter (TWTR) at $23 and the iShares Core S&P 500 ETF for $188.50. Financial guru Art Cashin who is often on CNBC, stated that historically, these sharp V shaped corrections rarely last. He didn't suggest we'd test the bottom, but that there would be some backing and filling in the next two weeks. That, coupled with the fact September and October tend to be bearish months for the markets, propelled me to raise some cash to take advantage of securities at lower entry points. And yes, I will be using limit orders.