Don’t Follow The Momentum

Markets of all varieties everywhere—stocks, bonds, gold, commodities—have recently been refreshed by steep rallies only to be terrorized moments later by sickening declines. The wild gyrations in the price of oil are certainly the primary villain, but there's another, more subtle force at work as well, namely trend and momentum following trading by literally thousands of trigger-happy investors.

Consider the most recent roller-coaster ride. During the first four days of the opening week of June, as the price of oil fell, retail sales beat forecasts and the ISM nonmanufacturing index rose, equity markets worked higher, with the S&P 500 surging through the key 1400 level and the NASDAQ Composite actually setting a new recovery high on June 5.

Early the next morning, June 6, a rumor spread that a prominent Israeli politician had said that Israel would have to destroy Iran's nuclear facilities. Although oil had fallen from $133 a barrel two and a half weeks earlier to $122 the previous day, the commodity trading funds, hedge funds and other maniacs who were short oil that Friday morning had itchy trigger fingers. The partially erroneous report triggered a buying panic that gained momentum as buying begat more buying and the stop-loss limits were set off. As the price of oil rose, the S&P contract sold off. Then, at 8:30 that morning, the Bureau of Labor Statistics reported that unemployment had jumped from 5 percent to 5.5 percent, the biggest one-month jump in 20 years, causing fresh concerns about U.S. economic growth. Suddenly a vision of stagflation emerged, and the selling of equities intensified, which, just as with oil, triggered more selling as more stop-loss orders and itchy trigger fingers were activated. It was the perfect one-day storm. For the day, oil jumped 13 percent and the major market averages fell more than 3 percent.

The billionaire hedge-fund manager George Soros recently told a congressional committee that such wild swings in markets, particularly in the oil market, were reminiscent of the crash of 1987. The crash of 1987 had a number of causes, but one contributor was the spat between U.S. Treasury Secretary James Baker and the German Finance Minister Gerhard Stoltenberg over divergent interest-rate policies between America and Europe. Unfortunately, today we are getting a repeat with the European Central Bank talking about raising rates even as the European economies slip into recession even as the Federal Reserve is committed to cutting rates while worrying about the weakness of the U.S. and global economy. Markets don't like the lack of coordination.

The crash of 1987 was also caused by what was then called "portfolio insurance," a supposedly high-tech but actually idiotic idea that promised you could insure your portfolio against losses by selling stocks when they went down. Of course when everyone did it, the waves of programmed selling caused a panic. The same kind of momentum trading is still very much the vogue today. Momentum trading (its advocates like to call it "investing," but it's not) is the strategy of buying strength and selling weakness. It is the exact opposite of Warren Buffett and value investing.

Hedge funds dominate trading in all. Most hedge funds have had a difficult year so far and are down anywhere from 2 percent to 3 percent to 8 percent to 12 percent. Hedge funds charge very high fixed fees (1.5 to 2 percent) and 20 percent of the profits because they supposedly can make money in bad markets. Obviously they are not performing as advertised, although the S&P 500 is down 7.5 percent, the main German and Asian indexes are off about 16 percent, and Japan is down 8 percent. Two of the hottest markets of last year, China and India, are off 41 percent and 26 percent, respectively.