Prepare for more frequent and extreme volatility. New and powerful influences, ranging from social media and financial technology to algorithmic trading and esoteric valuation models, will increasingly upset market stability and bring unprecedented rewards and unpredictable disaster.
Predictable market conditions will be upset by sudden unpredictable movements.
Financial markets can be predicted reliably only when the world does not change.
Even during periods of stability, judgment based on expectations and assumptions as much as hard facts and economic analysis, form the basis for buying and selling decisions. Market crashes and financial crises are a continuing and breathtaking reminder that markets are irrational and uncertain. Taken to an extreme, the combustible combination disrupts global markets and societies.
Clear and coherent markets, free from political agenda, bad compromises, and ineffective regulation is almost nonexistent. The consequences are usually pyrotechnic. It is not as if the world hadn’t provided ample warnings about the risks associated with irresponsible finance. History has centuries worth of such examples, but even looking at recent events over the last 25 years is illuminating.
In spite of Alan Greenspan acknowledging the “irrational exuberance” of the markets in 1996, stock market valuations continued to rise. The warning signs of unstable economies were believed to be localized and the broader markets decoupled from this turbulence. This was naïve thinking then and outright irresponsible now.
The idea that markets are uncertain, and consistent prediction is essentially impossible, is not new. John Maynard Keynes published a book on probability and uncertainty in 1921, with this concept of uncertain and irrational markets forming the basis of his general theory of financial markets. So, years before the stock market crash of 1929, and almost every 10 to 15 years afterward, the cycle of financial crashes and panics was predicted by a well-publicized thinker, and then, as is typical, ignored. The lesson is simple, and Keynes laid it out 100 years ago: markets seem rational but only during periods of stability. Markets are uncertain. Predictive models work most of the time, and that is their fundamental flaw. They will fail. Investment models that account for uncertainty and failure succeed in the long term.
The last few weeks highlighted the need to bring a new understanding of, and strategy for, investment risk. Volatility is increasing and occurring over a significantly compressed timeframe – for individual stocks and the overall market. Recent trading activity in GameStop, AMC, and a few other stocks demand an investment strategy focusing on Risk Adjusted Return. The new power of retail investors is here to stay, and that will shake up traditional portfolio managers because they are increasingly losing control of the trading process. Trading apps on platforms like Robinhood and social media chat rooms found on Reddit are game changers, fueling an unprecedented level of interest and activity (social media information is easily accessible and trading activity has very little friction – few, if any fees, and immediate). These two factors are irreversibly changing the market. In the past year, U.S. brokers added at least 10 million new retail trading accounts, and a shift to zero trading commissions late in 2019 unlocked a wave of activity that dwarfed even the wild days of the dot-com bubble. Beginning in early 2020, and coinciding with coronavirus lockdowns, trading activity started to surge and has not subsided, even as the economy has gradually reopened. Average daily trading at the biggest retail brokers hit a record of 6.6 million a day in December 2020. In January 2021, it reached 8.1 million. On January 27, 2021, equity volume was triple the average day in 2019.Retail investing has been a small fish trading in the large hedge fund and institutional pond. But that’s changing. Before the pandemic, retail trading made up about 15% of equity volume; now, it’s consistently making up more than 20%. The game changer is when that activity is concentrated on just a few stocks, a much more likely event among retail investors (driven by social media platforms), and it makes a substantial difference. In the case of GameStop and several other highly shorted stocks, it can cause startling price movements in a very short time.
