Part 1 excerpted from lesson 1 of the upcoming Trade Like a Pro ver.10 course.
This is No Longer 1984
I joined the Financial Industry in 1984, the year memorialized in George Orwell’s dystopian novel. I was young and worked with those who survived the deregulation and inflation of the ’70s. Many of the older brokers struggled with the changes going on around them. Technology changed how we related to the market. Solicitation changed how we related to clients. Many of the older brokers retired early in response. Today we face similar disruptions and changes, and again some will survive and some will not. The ability to adapt to change is part of our DNA. Humans are the most adaptable species on the planet. Recent changes in the markets will demand adaptation. We must know what has changed, be willing to adapt to the changes, and take decisive action to survive and thrive.
Change is gradual and rarely happens in an instant. Some new technology emerges and a few begin to use it, and create better results. Early adopters step in. Much later institutions and the industry become late stage adopters. Eventually some or all of the technology is adopted by the herd.
Electronic Markets Have Replaced the Open Outcry Markets
The open outcry exchanges declined as the markets became global. Today’s markets are virtual, electronic, and function twenty-four hours a day. The millisecond speed of execution and the immense volume of transactions grew exponential. In 1984 23 billion shares traded on the NYSE, which broke the 192-year record set the year before of 1.5 billion (source). Last year 1.3 Trillion shares traded on the electronic markets (source).
Dominance of Currency Markets
Bonds used to be the largest market in the world. Today the currency markets dwarf all combined stock and bond markets. The daily volume in currency trades is $5.1 trillion vs $84 billion for all Equity markets worldwide. This data is from the last Central Bank Survey in 2016. The gap has only widened since then.
Better Indexing with ETFs
ETFs have become the great hedge in the investing tool box of sovereign nation and hedge funds. The large selection of asset class and sector ETFs allow institutions to index the markets.
Institutional Hedging with Futures, Options, and ETFs
Institutional portfolios have always hedged their risk. Put options used to be a simple method of portfolio insurance. Later, futures replaced options. Today ETFs offer the best hedge for the institutional trader. They can match the sectors and asset classes represented in the main portfolio. ETFs are the new portfolio insurance.
Market Makers and HFT
A large percent of the market’s liquidity comes from market makers and high frequency trading (HFT). As volatility increases, computers take over much of the burden of creating liquidity. The exchanges pay the larger algorithmic traders rather than charge a commission. Their volume increase the markets liquidity. It also minimizes the spread between the bid and ask in normal markets. But this makes the extremes riskier.
Volatility and Fear
Peak to trough volatility as measured by VIX has not actually increased. The first quarter 2020 peak was below that of ’29, ’87, and ’08 (see chart for changes). But the recent last decade non-peak volatility is higher. And likely to remain so for the reasons already mentioned.
2008 Still Present in Investor’s Mind
The most memorable market year in my parent’s generation was the ’29 crash. The most memorable year for my generation was the ’87 crash. The most memorable year for the current generation is the ’08 crash and it is still top of mind for all generations. Clients are fearful. But 2020 may be the year we all remember the most. Because the 1st quarter 35% correction, COVID-19 and the quarantine have touched everyone. And moreso by what occurs between now and a return to normal. The uncertainty is what is most feared.
We are an industry of optimists and for decades that optimism gave the market a buy-side bias. When I entered the industry in 1984, the retail was a significant contributor to the world markets. That all changed in 2000. And no one rang the bell, to warn us of the change. Over the next seven years the market was invaded by a beneficial alien life-form. It grew in those seven short years to control 50% of all transactions of the market. By 2007 the non-human life form controlled over 75% of the markets. Last year for the first time our industry admitted the invasion was real. Bloomberg and JP Morgan announced that 85% of all transactions worldwide are traded by this beneficial invader. The retail market today is an insignificant rounding error on the world markets. Even the professionals traders have little influence.
Who is this beneficial alien invader? Algorithmic computer trading. In 2000 a few firms began to trade with computers. Today a tidal wave of transactions at the speed of light occur twenty-four hours a day, upending the playing field.
Why is this a concern? Because the retail market only makes money when markets go up. The trading range that formed the first decade of the new millennium garnered a negative return for investors over the ten years. But not so for the computers, which increased their coffers by hundreds of percent over the same decade. Computers like trading ranges. Unlike retail investors computers can make money whether the market is going up or down. Few firms allow fee-based accounts to profit from a decline in the market. Hundreds of billions of dollars were lost in portfolios in the first quarter of 2020. Never to be returned, because losses are permanent.
Each week for the next sixteen weeks we will discuss a lesson from the sixteen modules of the Trade Like a Pro course.
Probability and Decision Making: The Secret Behind Success in the Markets