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Ritholtz: Mom and Pop Learn to Outsmart Wall Street Pros

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Here’s a bit of role reversal for you: Mom and Pop were content to ride out the market’s volatility this past month, more or less sitting tight. Meanwhile, the pros were driven to the point of near panic.

What was all the fuss about? Take your pick. Perhaps the China slowdown will cause a global recession. Maybe the Federal Reserve is going to raise rates and kill the bull market. Oil prices might fall too far, destroying emerging markets. Or the U.S. economy is about to go belly-up.

Whatever the fear was, someone was there to give it voice. The downside of the Twitter era is that everyone has a megaphone, and any lack of wisdom of insight is no deterrent to broadcasting it. This month, that described Wall Street and not Main Street. It was the pros who lost it.

Click to enlarge. Source: Bianco Research via Bloomberg View 

Source: Bianco Research

Start with hedge funds. After missing a generational rally in which the Standard & Poor’s 500 Index tripled, hedge funds finally began going long U.S. equities — just before the China trap door swung open. The Wall Street Journal reported that many funds got shellacked this month, giving up all of their year-to-date gains in a week. Bridgewater, Omega, Third Point and Pershing Square all took a beating, but only Omega seemed to be positioned to capture the bounce-back rally (note that I am not objective, as you can hear in my Masters in Business podcast with Omega founder Leon Cooperman).

Beyond the hedge funds, the algorithmic traders seemed to have run amok as well. It is a natural human response, to borrow from Daniel Kahneman’s book “Thinking, Fast and Slow,” to react emotionally first and logically second. However, no one can think faster than a machine, and the algos managed to engage in some very fast, and what looked like emotionally driven trading. As we saw this week, that sort of behavior was amply punished. My colleague Josh Brown summed it up in a post, “Computers are the new Dumb Money:

“You want the box score on this latest weekly battle in the stock market?

“No problem: Humans 1, Machines 0

“Because if you think it was human beings executing sales of Starbucks (SBUX) down 22% on Monday’s open, you’re dreaming. And if you believe that it was thinking, sentient people blowing out of Vanguard’s Dividend Appreciation ETF (VIG) at a one-day loss of 26% at 9:30 am, you’ve got another thing coming.”

Sometimes instantaneous is too fast; occasionally the best thing to do is absolutely nothing. As Gillian Tett of the Financial Times noted, computers have come to dominate the trading volume of stock exchanges:

“Orders are being executed at lightning speeds in huge volumes. But there is another, often overlooked implication: these machines are being programmed to link numerous market segments together into trading strategies. So when computer programs cannot buy or sell assets in one segment of the market, they will rush into another, hunting for liquidity.”

All this is part of a long series of adaptations by Main Street investors to the newest new thing, and the countermoves by the (alleged) pros. In response to this, Mom and Pop have wised up: they trade less and invest more. They are tuning out more of the noise, sending CNBC ratings to record lows. They are eschewing stock pickers, and embracing index and exchange-traded funds. They have figured out that the way you beat high-frequency trading is with low-frequency investing.

Speaking of which, the new dumb money got scalded by ETFs. Although U.S. equities as a whole never fell more than 6 percent, there were widely held ETFs that temporarily lost one third of their value.

Ben Carlson described this as the ETF flash crash:

“In the early minutes of the stock market open on Monday morning things got a little crazy. After a huge whoosh down in overnight futures trading, the NASDAQ fell almost 9% while the S&P 500 was down around 6% right after the opening bell. Watching it in real time was a sight to behold. Less than 15 minutes later, a huge chunk of those losses were recovered. Many individual stocks saw even larger moves.”

Mom and Pop outwitting high-frequency traders; hedge funds being beaten by Main Street. It’s enough to give a long-term investor some hope for the future of finance.

— Check out Ritholtz: A Real Estate Recovery That’s Not Quite There on ThinkAdvisor.


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