We are clearly now in a new regime of volatility. As evidence, the Dow Jones Industrial Average has experienced a daily change of greater than 100 points in 14 out of the last 15 trading sessions.
There is little doubt that the reduced level of liquidity in direct response to the Federal Reserve's tightening pivot has contributed to this new bout of volatility. And, arguably, so have some other factors, such as an untethered president's hastily crafted policy, conflated with politics and delivered over Twitter.
As liquidity evaporates, leveraged ETFs and quant strategies, governed by machines and algorithms, take on an even greater role in impacting our markets.
Everyone knows that the risks associated with the proliferation of leveraged ETFs, which tend to exacerbate short-term swings in stock prices, and the trading dominance of quant strategies (e.g., risk parity) possess the potential for another Flash Crash.
I increasingly can imagine a spin-out into a disaster that would be difficult to recover from.
The frequency of wild, unpredictable and precipitous market swings and moves that are divorced from fundamentals -- other than explanations in search of problems after the fact -- are unarguable. They produce an unnerving artificiality and lack of natural price discovery and precipitate more bouts of volatility.
The business media generally have ignored the causality between levered ETFs and quant products, preferring instead to rejoice in 500-point rallies in the Dow Industrials and to hold "Markets in Turmoil" specials when the DJIA falls by 400 points. The enormous swings in both directions impact confidence in the markets and cause retail investors to buy when they should not be buying and to sell when they should not be selling. (See this Jim Cramer column from last Friday.)
In its extreme, it erodes the ability of companies to raise capital and create jobs.
ETFs were supposed to be a low-cost democratizing vehicle that brought cheap tax-efficient diversification. Over the years, ETFs have expanded to double and triple leverage (short and long), representing with quant strategies the largest portion of the volume on exchanges and have become vehicles for everyone other than Main Street. They're used by macro strategists whose algorithms correlate away and are only sometimes correct.
Meanwhile, exchanges that used to be self-policing institutions dedicated to clean and transparent markets are now public. They make their money on the volume generated by high-frequency and quant strategies and products, selling special data feeds to the perpetrators of this mess.
The Securities and Exchange Commission (SEC) is all over Elon Musk's ranting, but nowhere for years on a matter that is fundamental to health of American markets. (The ultimate irony, as discussed in this Wall Street Journal column, is quant king D.E. Shaw's human-being traders are losing money.)
In The Great Recession of 2008-2009, Warren Buffett famously called derivatives "financial weapons of mass destruction." The newest financial weapons of mass destruction -- leveraged ETFs and quant products and strategies -- are destabilizing, sabotage natural price discovery and corrode investor confidence.
A Computer Lesson From 1987 Is Still Unlearned
Today's "financial weapons of mass destruction," though not as venomous as the last cycle's contrivance, represent a structural threat to the capital markets not seen since Portfolio Insurance devastated the U.S. stock market in October 1987.
As a first step I would recommend that CNBC, Bloomberg and Fox Business immediately invite SEC Commissioner Jay Clayton on their networks to discuss why the SEC removed the "uptick rule" and why they allow the New York Stock Exchange to rent space to the High-Frequency Trading crowd in order to get closer to exchange computers (and to get a split- second advantage over the public).
It is imperative that the SEC evaluate the harmful impact of leveraged ETFs and quant strategies and products for the purpose of creating needed regulations before our markets are further undermined.
(This commentary originally appeared on Real Money Pro on Feb. 22. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)