God is a Capitalist

Monday, June 19, 2017

PhD’s and computers explain market volatility since 1980

Richard Bookstaber’s 2007 work, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, examines the huge increase in stock and bond market volatility since 1980. He notes that GDP volatility has shrunk while market volatility has increased. And if you graph the S&P 500, especially the year-to-year change, the massive increase in volatility is obvious.

Bookstaber, who has a PhD from MIT, writes that before the rise of computer trading, investment banks tended to hire college graduates who were also former athletes because managers thought they had the right temperament to handle the stresses of trading. Then computers came along and of course they need models to work with. Who had better models than PhD professors at universities? So the banks loaded up on PhD’s to create models for computer trading.

Bookstaber provides an insider’s account of the victories and tragedies of investment banking and arbitrage trading from the mid-1980s on because he labored in the trenches as a risk analyst, much of the time with Salomon Brothers. Two things stand out to Bookstaber: computer trading and innovation.

The problem with computer trading, especially in the crash of 1987, was that the computers do what they’re programmed to do. The PhDs had invented “insurance” for the market by selling futures contracts. That’s not really an innovation in financial markets, though. Agriculture and mining had been doing that for 300 years. They just adapted the principle to the stock market. The PhDs told the computers to sell more futures (increase the amount of insurance) each time the market fell. But when the government changed a policy that causes large numbers of investors to begin selling, the computers reacted by selling more futures, which in turn caused cash prices to fall enough to catch up. The market was diving like an airplane with the computers pushing the throttle forward and adding to the speed.

Bookstaber writes that the structure put in place to reduce risk in the market has instead added risk. 
The irony is that the structure has features that at face value are desirable, in some cases approaching the essential elements of the ideal. As with many ideals, its origin is in academia, in this case a theoretical framework that underpins a half-century of work in financial economics called perfect competition.
Perfection competition is a fiction that socialists invented decades ago as a club to bludgeon capitalism. In that imaginary world, all products are exactly alike and no producer or consumer is large enough to cause price changes, so prices change randomly.
Bookstaber devotes most of a chapter to the problems with pretending the fiction of perfect competition applies to the real world. The PhDs in charge of trading thought that they weren’t impacting the markets they traded in and that when the time came to unwind trades they would be able to do so without affecting prices. The old athlete traders never would have accepted such nonsense. The PhDs should have seen they were trading in an oligopoly market, in which case they would have employed game theory instead of calculus in their models. But they never saw it and probably don’t see it today.

At the same time, every investment bank was hiring PhDs to model their trades. That meant that they were all doing the same trades and they all knew what the others are doing. As a result, when one company, like LTCM got into trouble in 1998, its competitors knew it was in trouble before its management did. LTCM, btw, had two Nobel-Prize winning PhDs working for it.

LTCM needed to unwind some trades to pay bills, which meant it needed to sell some bonds, at that time Russian ones. But competing banks understood that LTCM’s selling would drive prices down and so all potentional traders refused to buy, not wanting to be first. Banks saw the trouble they were in and refused loans to bail them out. So LTCM had no choice but to keep selling bonds in order to pay bills which kept prices falling further and put the company in a tailspin.

Even though he mentions it in his book, the author attaches little importance to the fact that almost all financial crises begin with the government intervening in the market and doing something stupid that is the financial equivalent of yelling “fire” in a crowded theater. Everyone rushes for the exits at the same time and many get trampled.

Another issue Bookstaber misses is the Fed’s role in financial crises. He points out the times when the Fed changed its interest rate and ignited chaos in the markets, but he clearly doesn’t know the Austrian business-cycle theory and how the Fed’s manipulation of the money supply causes the “random” events that roil the markets.

Bookstaber’s tales make for riveting reading, but what does it mean for investors? We need to realize that PhDs and computers are here to stay and as a result the markets will be much more volatile. The highs will be higher and the lows much lower than a few decades ago. In rodeo terms it means the bulls are meaner, jump higher and kick harder. But regardless of what the PhDs and computers do, the market has to bow to the real economy once in a while. The market will be much more volatile than the business cycle, but understanding the Austrian business-cycle theory will give investors an unfair advantage.

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