Like Something Out of 'The Twilight Zone,' This Market Is About the Machines

 | Jun 14, 2017 | 9:30 AM EDT
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(This commentary originally appeared on Real Money Pro at 7:10 a.m. ET today. Click here to learn about this dynamic market information service for active traders.)

"Let's consider that statement. In the last 20 years the VIX closed lower than 10 on a total of 11 days, and 7 of those days were in the past month. Think about that - over the past 2 decades, was the last month the most benign macro environment? (e.g. last week: Comey testimony, UK elections, ECB, geopolitical uncertainty, Qatar, FANG flash crash, etc.)."

-- Marko Kalonovic, JPMorgan's head quant

I vividly remember episode 40 of Twilight Zone entitled "A Thing About Machines." (Here is a clip of the episode)

Originally aired on Oct. 28, 1960, it's the story of a repairman who pays a house call to Bartlett Finchley, who is having trouble with his television's reception. Finchley is an ill-tempered and lonely gourmet magazine critic. He abuses machines in his home and he is as inept with human beings as he with the machines, which he concludes are conspiring against him.  

Though Finchley is seen as paranoid by many, eventually every machine in the house (including his car) turns against him: 

* His typewriter types out the message, "Get out of here Finchley."

* A woman on the television speaks the same message.

* His electric razor rises menacingly in the air and lunges at him.

* An unplugged telephone has a voice that speaks the same words as the typewriter. 

Finchley drinks a bottle of liquor and passes out. When he awakes, the machines in the house tell him to get out and the razor pursues him. He runs out of the house and is chased by his driverless car, which winds up pushing him into his pool. 

Sinking to the bottom, Finchley drowns. When the police pull him out, they can't explain how he could sink to the bottom when not being weighed down, as normally a body would float, nor could they explain the car near the pool. 

Listen Luddites, for the stock market, too, it's a thing about the machines

Throw away your fundamental analysis, your price charts, interest rates and economic growth forecasts, as the market has lost its moorings. 

It is no longer a pyramid of fundamental and technical analysis nor is it a response to changing investor sentiment. 

The ongoing multiyear changes in the market structure and dominant investor strategies in which quants, algos and other passive strategies (e.g., ETFs) have replaced active managers raise the same risks that Finchley faced 57 years ago. 

And the overwhelming impact of central bankers' largesse is the cherry on the market's non-fundamentally influenced sundae. 

As I have written: 

"The combination of central bankers' unprecedented largesse (and liquidity) when combined with mindless quant strategies and the enormous popularity of ETFs will, as night follows day, become a toxic cocktail for the equity markets. While we live in an imperfect world, we face (with valuations at a 95% decile on a number of metrics) a stock market that views the world almost perfectly." 

Back to JPMorgan's Marko Kalonovic, who is quoted at the top of this piece and again here: 

"... some striking facts: to understand this market transformation, note that Passive and Quantitative investors now account for ~60% of equity assets (vs. less than 30% a decade ago). We estimate that only ~10% of trading volumes originates from fundamental discretionary traders. This means that while fundamental narratives explaining the price action abound, the majority of equity investors today don't buy or sell stocks based on stock-specific fundamentals.

The next and perhaps just-as-important driver is, of course, central banks, based on Kalonvic's analysis: "With ~$2T asset inflows per year, central bank liquidity creates strong interest rate and policy sensitivity for sectors and styles. Low rates also invite investors to sell volatility."

Everyone should read this important note from JPMorgan's head quant (hat tip to Zero Hedge) in order to understand how risk parity, volatility trending, stat arb and other quant strategies that are agnostic to balance sheets, income statements and private market value artificially are impacting the capital markets and, temporarily at least, are checking volatility. 

Last Friday's market schmeissing was the first shot across the bow. There will be many more of those Fridays. 

This is not my Grandma Koufax's stock market.

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