+++ (BBG) Machines Had Their Fingerprints All Over a Dow Rout for the Ages

(Bloomberg) — Risk parity funds. Volatility-targeting
programs. Statistical arbitrage. Sometimes the U.S. stock market
seems like a giant science project, one that can quickly turn
hazardous for its human inhabitants.
You didn’t need an engineering degree to tell something was
amiss Monday. While it’s impossible to say for sure what was at
work when the Dow Jones Industrial Average fell as much as 1,597
points, the worst part of the downdraft felt to many like the
machines run amok. For 15 harrowing minutes just after 3 p.m. in
New York a deluge of sell orders came so fast that it seemed
like nothing breathing could’ve been responsible.
The result was a gut check of epic proportion for
investors, who before last week had been riding one of the most
peaceful market advances ever seen. The S&P 500, which last week
capped a record streak of never falling more than 3 percent from
any past point, ended the day down 4.1 percent, bringing its
loss since last Monday to 7.8 percent.
“We are proactively calling up our clients and discussing
that a 1,600-point intraday drop is due more to algorithms and
high-frequency quant trading than macro events or humans running
swiftly to the nearest fire exit,” said Jon Ulin, of Ulin & Co.
Wealth Management in Boca Raton, Fla., in an email.
Futures on the Dow and S&P 500 were up about 0.8 percent as
of 7:30 p.m. in New York.
To be sure, not all of the rout requires inhuman agency to
explain. Markets are jittery. Bond yields had been surging and
stock valuations are approaching levels last seen in the
internet bubble. Much of today’s selloff was perfectly rational,
if harrowing — particularly coming after last week’s plunge in
which the Dow fell 666 points on Friday.
Observers looking for an electronic villain trained most of
their attention on the roughest part of the tumble, a 15-minute
stretch starting about an hour before the close. That’s when an
orderly selloff snowballed, taking the Dow from down about 700
points to down a whopping 1,600. It quickly recovered.
“What was frightening was the speed at which the market
tanked,” said Walter “Bucky” Hellwig, Birmingham, Alabama-based
senior vice president at BB&T Wealth Management, who helps
oversee about $17 billion. “The drop in the morning was caused
by humans, but the free-fall in the afternoon was caused by the
machines. It brought back the same reaction that we had in 2010,
which was ‘What the heck is going on here?”
It may never be clear what accelerated the tumble — people
still aren’t sure what caused the flash crash on May 6, 2010.
Unlike then, most of the theorizing about today’s events
centered not on the market’s plumbing or infrastructure, but on
the automated quant strategies that gained popularity with the
advent of electronic markets last decade.
Particular suspicion landed on trading programs tied to
volatility, mathematical measures of which exploded as the day
progressed.
How pervasive such strategies are in the U.S. stock market
is a point of debate, though everyone agrees they’re big. After
a similar downdraft struck equity markets in August 2015,
JPMorgan Chase said shifting signals from volatility and share
prices threatened to unleash $300 billion of selling pressure on
equities.
Since then, it’s become de rigueur to implicate systematic
strategies whenever a selloff lands on investors. The firm’s
chief derivatives strategist, Marko Kolanovic, said signals sent
to systematic traders, first by last week’s slowdown in the
rally and then the Cboe Volatility Index, played a central role
in Monday’s downdraft.
“Midday today, short-term momentum turned negative,
resulting in selling from trend-following strategies,” he wrote
in a note to clients. “Further outflows resulted from index
option gamma hedging, covering of short volatility trades, and
volatility targeting strategies. These technical flows, in the
absence of fundamental buyers, resulted in a flash crash at
~3:10 pm today.”
Theories on how machines interact with share prices have
evolved since the days of the Flash Crash, the market rupture of
May 6, 2010, in which the Dow average fell about 1,000 points
before reversing. Back then the expectation was that something
had gone wrong on the electronic exchanges where shares trade —
something that was roundly denied this time.
“There was not a single self-help; there were no outs;
there were no fat fingers that we saw,” Doug Cifu, CEO of high-
speed trading firm Virtu, told CNBC. “There were no busted
trades, no repricing. It was just an avalanche of orders around
3 o’clock-ish.”
Nowadays the first suspicion alights on computerized
traders who operate everywhere.
At the same time, a case can be made that the machines are
doing the same thing any human trader would do given a certain
set of economic facts, only faster. Inputs into automated
strategies sound complicated but often are just versions of
signals familiar to earlier generations: momentum indicators
that show if an advance is getting ahead of itself or a decline
is turning into a plunge.
“There were a lot of stops, old fashioned stops triggered
and some algorithm trading,” Scott Wren, senior equity
strategist at Wells Fargo Investment Institute Inc., said in an
interview on Bloomberg Television. “This is a technically driven
day. You watch the 50-day average. It might be a magnet.”