Attack of the stock market zombies
The stock market’s gyrations over the past few weeks have been breathtaking—and not in a good way. Corona virus fears have dominated the markets and the global economy seems to be lurching inexorably toward recession. With all the stress in the market, it is understandable if you are feeling some personal stress, too.
In all this turmoil, a lot of people have been asking me why the market has become so volatile. Most people understand that the COVID-19 scare is having a significant effect on global economic growth and that slowing growth will cause stocks to fall. But why is the stock market bouncing all over the place? Shouldn’t it just settle lower? Why are the up and down moves so huge? What is happening?
I’m sure there are many answers to this question, but the most likely answer in my mind is market zombies. That’s right—zombies. If you don’t believe me, ask yourself: would any rational, thinking human being drive the market the way it has been driven for the past couple of weeks? No way. This market has zombie fingerprints all over it.
Market zombie is the term I use for algorithmic trading—a technical term that means computer-driven trading. With algorithmic trading, a computer trades stocks when it detects a potential money-making opportunity. It could be a small aberration in pricing or a barely perceptible change in momentum. Whatever the trigger, the zombie pounces on the opportunity and devours it in good zombie fashion. This may be fine when one or two zombies are at play, but a whole pack of zombies chasing the same thing can cause extreme market reactions.
The first market zombies were spawned in the mid-1980’s just as I was graduating with my MBA. Years earlier, a few academics caught hold of an idea which they called portfolio insurance. The idea was to sell stock index futures as the market dropped in order to offset losses in a portfolio of stocks. Relatively simple computer algorithms drove the trading. The more the market fell, the more stock index futures were sold. If the stock market rose, the algorithm purchased the futures contracts back. Everything worked fine until Black Monday—October 19, 1987. That’s when the zombies attacked.
Black Monday was the final day of a multi-day sell-off that started the Wednesday before. Between Wednesday and Friday, the Dow Jones Industrial Average dropped a total of 10.8 percent on increasingly heavy volume. Portfolio insurance zombies tracked the market decline with sales of their own. Over the course of the weekend, the zombie sell orders continued to build. From my vantage point on a derivatives trading desk in L.A., I watched the wave of selling roll like a tsunami from market to market around the world until it reached the opening of the U.S. stock market. As our market opened, it was quickly overwhelmed by the massive sell orders that had built up over the weekend. By the end of the day, the Dow Jones Industrial Average was down 508 points or 22.6 percent—its largest single-day drop in history. The S&P 500 futures contract fell 29 percent.
The market zombies did not cause the market to fall on Black Monday, but they probably turned a normal decline into a historic rout. Likewise, today’s market zombies aren’t causing the corona virus pain, but their efforts to exploit it have probably made it worse.
The zombies in today’s market are much more sophisticated and dominant than they were on Black Monday. On any given day, algorithmic traders account for as much as 80 percent of the trading volume on U.S. exchanges. Trading curbs, like the one triggered on Monday, can help protect markets from zombie-fueled extremes. In fact, the triggers we have today were put in place in response to the Black Monday experience with algorithmic traders.
One final word: while the actions of algorithmic traders often magnify market volatility, their influence is usually short-lived. They are not focused on fundamental value so try not to get caught up in their games. Your best bet is to stay focused on your long-term objectives. Your discipline is your best protection.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.