If you attended a holiday party recently, you could not escape the market conversation. On Christmas Day, a wealth manager from a reputable firm told me, “There was so much selling yesterday that I expect the market to drop as much as 2,000 points tomorrow.” I was alarmed. The next day, the market rose by 1,086 points — the largest single-day point gain in history.
Most people call the Dow Jones Industrial Average “the market,” but that is only the 30 largest publicly traded stocks. Then there is the S&P 500 and the Wilshire 5000, a market-cap weighted index of all U.S. stocks with readily available price data — that is, an investment you might actually trade. The last time the Wilshire 5000 had over 5,000 equities was in 2005; it grew to a high of 7,562 in 1998 and today counts only 3,600.
After you remove trusts, REITS, and other investment vehicles, there are relatively few operating companies to choose from — perhaps 2,800. In 2017 there were 9,356 U.S. mutual funds; domestic equity funds represented 43 percent of those, or about 4,023 funds. Add to that the 1,756 U.S.-based Exchange Traded Funds (ETFs) and you’ve got 5,779 packages for 2,800 candidates.
We delight in packaging up financial assets, which makes the risks inscrutable and shields us from recrimination, guilt, and analysis. We have convinced ourselves that we can rationally select from 5,779 bundles, but not from 2,800 more discrete risks. Bundling financial assets is sold as a way to distribute your risk, but it can also ensure that your basket has some garbage in it. Sometimes, the sellers stuff your basket with junk because the commissions are just too enticing, which happened in the mortgage crisis of 2008. Who knew that no one was paying for all those houses?
Perhaps you follow “the market” on financial TV channels, which offer two stories: “Investors today are concerned about X, and so the market dropped” and “Investors have priced in their concern about X, and so the market rose.” Who are these investors? No investors speak because of the real risk of appearing foolish.
In fact, 75 percent (or more) of trades are made by algorithms (“algos”). You and I may use simple instructions like “Sell if the price increases by 100 percent,” while more complex automated algos are matching patterns against historical and recent price movements to game you and their equally sophisticated competitors.
Algos also measure terabytes of words in tweets, articles, and news streams for market sentiment. Add the ability to throw huge pools of incremental investment at any situation, and the machines can create price swings that frighten humans into selling or entice them into buying at all the wrong moments. As in a casino, we tell ourselves that we have “a feeling about the market,” and we are wrong. We end up giving away our money to the best machines.
Some of those machines are operated by Renaissance Technologies, whose founder, James Simmons, topped the hedge fund money list for the last three years, earning $1.7 billion in 2017 alone. Renaissance’s Medallion Fund, which caters mostly to its predominantly scientific and mathematical employees, earned 71 percent annually from 1994 to 2014. Your gut is up against the best technology in history that is designed to suck money out of the market.
Even weirder, artificial intelligence has what is known as the Black Box problem. Because machines can recognize multivariable patterns beyond our comprehension — and more quickly — we really don’t know what they’re thinking. We can’t see inside that box while the market is moving, and the boxes are all competing against and allying with each other to maximize their trades, so many, if not most, of the swings in the market could now be driven by intelligent devices whose logic we don’t truly understand.
In the realm of understanding, only one person has contributed much wisdom lately, and he has been widely quoted. He may know the global economy better than government statisticians because his company monitors world-wide shipments in real time. FedEx Chairman and CEO Fred Smith said, “Most of the issues that we’re dealing with today are induced by bad political choices … making a bad decision about a new tax, creating a tremendously difficult situation with Brexit, the immigration crisis in Germany, the mercantilism and state-owned enterprise initiatives in China, the tariffs that the United States put in unilaterally. So you just go down the list, and they’re all things that have created macroeconomic slowdowns.”
Politicians can destroy wealth as happened in Venezuela where the country squandered its oil riches, and the economy became so dysfunctional that the average citizen lost 24 pounds. But politicians can also, if inadvertently, create wealth. Jack Ma, the founder of Alibaba and the richest man in China, likes to say that the U.S. spends too much on defense. He may be right, but he seems to forget that his fortune is based on one of the U.S. Defense Department’s most successful creations — the distributed communications system that became the Internet.
These are things that influence the market that we cannot know: the future of most financial bundles with hundreds of moving parts, what’s going on with high-speed algos, and what problems politicians will create. These things we know: human beings are tool users, and we place a high value on new, better tools. There is a relatively small universe of companies that have low debt, enough cash to weather a downturn, and increasing, profitable sales of new technologies. Over the long-term, some of these will outperform the market.
Benjamin Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Since we cannot know “the market,” let us endure the slings and arrows of short-term losses in solid companies in the hope that they grow, are properly weighed, and reward us for our analysis and patience.
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A 1979 graduate of Princeton University, Paul founded Clancy Paul Computers in 1981. After selling the business to a national firm in 1989, Paul has engaged in a variety of business endeavors, ranging from an online photo processing company to a firm that helps nurses diagnose wounds and order proper wound care materials from a patient’s bedside. Several years ago Paul, who lives with his wife and children in Titusville, started the Trenton Digital Initiative to help bring affordable Internet connectivity to financially challenged families.