Quants Offer Advice to Help Investors Navigate Bear Market

Quantitative Analysts

Quantitative analysts, called quants, employ mathematical and statistical models to understand things. Two of them are now stepping up to provide investors with their insights.

Quantitative analysis is used in many fields to seek to understand various processes by seeking to quantify data and provide models. They are particularly widely used in the world of financial analysis, and especially in the study of the movement of the prices of assets to seek to better predict future movements.

Known as quants, these analysts play a huge role in all of the program trading that we have today, which dominates the landscape of financial markets. Nowadays, the majority of the trading that goes on in the stock market for instance isn’t humans placing trades, but computers placing them based upon their programming, using trading rules that have been designed by quants.

Quantitative analysts are related to their cousins, technical analysts, although quants focus more on strict modeling than technical analysts do. Quantitative analysts could be considered a branch of technical analysis, as both study data that affects markets directly, as opposed to fundamental analysts who study business and economic data.

Since technical analysis studies the behavior of the market itself, including what quants do, it delivers superior analysis in the shorter term. Our current market virus is a great example of the distinction between what these various analysts do, and in times of high risk and volatility, this is where technical analysis really outshines their fundamental brothers, because we become even more disconnected with business performance when we are in the midst of a panic.

Technical analysis is only concerned with measuring and predicting momentum, where the participants move markets in one direction or another based upon whatever is driving their behavior. In today’s crazy market, this happens to be caused by the coronavirus scare, but may include anything. To a technical analyst, it doesn’t even matter why things are moving, as this does not matter on the scale they use, the next bar on their chart.

This has them constantly taking the pulse of the market and deciding which moves are significant enough to reverse a trend in momentum and which ones are considered to be less significant and treated as noise. Technical analysts operate on any timeframe, from tick by tick charts to monthly ones, although they do tend to focus more on the shorter-term stuff, up to and including daily bars.

Fundamental analysts confine themselves to certain types of data that the market relies on, which mostly focuses on near-term earnings expectations of the companies that they study. They would tend to see something like our sick bear as being a short-term overreaction, seeing the drop in stocks being overdone, but they don’t really have the tools to take advantage of these things because they have not chosen them. They are the people who will tend to hold fast to their positions regardless of what deviations we see from what they consider to be value, because these near-term earnings are all they choose to use.

When we see a big drop like we just saw in stock prices, this will actually cause them to want to hang on to their positions even more than otherwise, because they perceive greater value in the stocks at these lower prices. Technical analysts just see the price go down in a way that is very convincing and seek to profit from these moves by riding the waves up or down in the direction that they are moving.

Quants, on the other hand, put a lot of stock in the movement of stock prices, but they also look to quantify what may be going on to drive these movements. When this virus panic set in, fundamental analysts were thinking that they should hold because the stocks are likely to come back, quantitative analysts will study what is putting them down and look to measure the likelihood of the momentum continuing based mostly upon that, and technical analysts will just watch the charts and only care about when the trend shifts, whenever that may be or for whatever reason.

Fundamental analysts will therefore dig in their heels during these times, acting as contrarians, technical analysts will ride the move down, and quants will perceive how much fear there is out there and decide on how this may continue to influence prices. Quants will also actively participate in this, adding to their positions as the fear mounts, and this sort of trading is actually primarily responsible for the huge hit that the market has taken, since they rely on news so much.

Both quants and fundamental analysts therefore focus a lot on factors external to price, price influencers in other words, like earnings projections with fundamental analysts and any outside factors that may influence prices with the quantitative analysts. Quants therefore distance themselves from what is going on like fundamental analysts do, but they at least take a broader view than just looking at one thing.

There’s been lots of examples of this, for instance when President Trump is speaking and the markets shoot up, or down, it’s the quants that are mostly driving this momentum. He announces a stimulus package for instance, and the army of computers perceive this and start going crazy. They take both the movement and the news into account, where technical analysts just see the price rising and get on board to ride it.

Fundamental analysts, meanwhile, are left to try to figure out how this will impact stocks and the economy, and will miss these moves because they have their eyes focused on months from now, while the real action is taking place right before our eyes in real time. They may have their beliefs that certain stocks or the market will be higher at some future point in time, but the path there isn’t really mapped out very much.

All of these things have their place, although we never want to just rely on fundamental analysis because the role of the market always matters, their being excited about prices going up or afraid that things will collapse, and we always have some of this going on at any given point in time. They ignore investor behavior altogether, and assume that investors will act a certain way only, and they often act quite a bit differently than the models of these analysts account for, leaving them in discord with reality.

Fundamental data is important with a long-term view, but these analysts ironically focus too much on the nearer term, the next year ahead for instance, and miss both the period up until then and the period after as well. A good example of this would be the terrible performance of oil stocks, whose stocks have underperformed their business results for a long time now, and the reason is that their longer-term view, beyond the horizon of fundamental analysts, isn’t so bright.

Quants Seek to Take the Known and Expand it Through Statistical Analysis

We might think that quants take a more balanced approach to this, and while using data that is moving markets such as what we have going on now, worries about the economy, worries about earnings dropping or being excited about their rising, and whatever else they add into their mix of decision making, would make their predictions more relevant, but as it turns out, there is nothing more relevant to the behavior of markets than the behavior of markets itself, the things that technical analysts look at.

The coronavirus alarm got sounded, and the quants immediately sold and kept selling. Technical analysts heard the alarm and waited until this really started playing out on the charts, and once the market told us that it was ready to sink, this is when they looked to jump on. Fundamental analysts heard the same bell but did their best to block it out because it just didn’t ring true enough with their model, especially after we extended the move down to territories that they consider to be too much.

When you have big moves like this in either direction, you definitely should want to be on the side of momentum, and while both quantitative analysts and technical analysts base their decisions primary on momentum, the phenomenon doesn’t exist for fundamental analysts, who just choose to ignore it because they have chosen not to let it influence them.

Quants also look to study price patterns in themselves, for example how markets trade during the last half hour of the day, or at various times throughout the day, and then look to combine this data with what is actually going on, to seek to gain an advantage by using this additional information. The problem with this extra data doesn’t always influence prices like they think, where if you are approaching the moves from a technical perspective, you always just listen to the moves as they speak to us, and therefore won’t be disconnected from their message by any extraneous data.

How much we use the data that quants look at from a macro perspective is what is at issue, because you don’t want to ignore these things and still want to be guided by them to some extent, although we need to realize that the market has the last say. On a micro level, they look at things like what types of stocks are doing well in such a time, and this is something we all need to use otherwise we would have a very difficult time figuring out what assets to buy and sell.

As big a role as quants play in today’s markets, they are a pretty quiet gang overall. We got a chance to hear from a couple of them recently, and they shared some thoughts with the investing world about how their kind would understand and approach markets this turbid.

Since we’re trying to best predict the future, we should never be willing to limit our views to a particular school of thought, to a particular model or methodology, and we should be willing to consider any data that we have. We will then give this data various weightings from extremely important to meaningless, but we want to be both embracing and shunning data based upon relevance in the real world and not just how relevant something may be to our preconceptions.

When we seek to view the world as it appears rather than blocking out certain frequencies with special glasses, we will minimize the distortions that so many others see. Quants do have something to say to us, even though we may not choose to trade the way they do, and we actually need to seek better methods than they do.

Joe Mezrich of Instanet describes the macro view as well as anyone could right now. “The emotional dimension of this is extraordinary,” he remarks, and that sums up extremely well what fundamental analysts are missing right now. We could describe this phenomenon as the mood of the market, which ranges from euphoric to panicked, and there’s no question where we are here right now.

The mood of the market is a huge influencer, and we could even say that there isn’t anything else that influences prices at all. This is what causes any and all deviations from whatever models we construct, and when our models and the mood of the market disagree, this leaves us dead wrong every time, by definition even.

Mezrich’s work has him delving into such things as looking at what types of stocks are performing better than others, even though if all types are performing as poorly as they are right now, this is like measuring dents on your car and liking the smaller ones, even though we should never become happy about getting hurt less over more.

He feels that momentum stocks are preferable over the broader market, and while we would expect this to be true normally, we wouldn’t think this would be the case during a big sell-off, as these stocks tend to be more volatile than average.

This actually has to be the case for a stock to make it on someone’s momentum list, because this means that it is moving up faster than average to qualify. What moves up faster tends to move down faster than average as well.

Mezrich points out that as of last Wednesday, when the S&P 500 was down 13% year to date, the iShares Edge MSCI USA Momentum Factor ETF was only down 7% year to date. He points out that 6% better does mean something, but avoiding some of that 7% matters as well.

Without even looking at the charts, we can surmise that this has happened because this index has outperformed the broad market up until the big fall and had more to give. Sure enough, we see that this ETF had lost 16% from February 18 to last Wednesday, and not in a way that should have inspired any confidence of bullishness. The S&P 500 was down 18% over this time, a little more, but not all that impressive of a difference to want to take a single instance and try to generalize like this.

We do not want to leave the defining of momentum up to a fund like this, as they are far too slow to react at the best of times and certainly not in times of panic like we’re in now. If we are judging stocks by way of their positive momentum, maintaining this needs to be the defining factor as far as whether they go or stay on our list, and losing 16% in three weeks is not exactly bullish momentum.

We need to especially avoid stocks that have not only lost the momentum that they had in our direction but have established a huge amount of momentum against us, but we can also apply the concept of momentum to the fund itself, and only hold it when it has the right kind of momentum. This last three weeks have clearly been the opposite kind.

It’s not that this is even a very good performing ETF right now anyway, as it did not even manage to keep up with the market last year. The point here though is that we need to do a little quantitative stuff on the fund itself to see how it really stacks up before we get too excited about it.

The Numbers Can Reveal a Lot, But We Need to Look at the Right Ones

One thing about quants is that, since it’s all about the numbers, they tend to get the fact that numbers mean the same whether they are going up or down, to an extent far beyond how the great majority of investors think. Mezrich admits that he feels some of the same emotions as investors do when stocks sink as fast as they did lately, but he is able to set this aside and approach the problem from a more practical perspective, looking to make money on either side of a move if the situation presents itself.

When we see the numbers change on our account balances, the number does not ask whether this money was made or lost on the long or short side. Neither should we, as this makes no sense from any perspective, quantitative or otherwise.

Mezrich pointed out how well short sellers have done lately, especially those who have shorted high beta funds such as the ProShares UltraPro QQQ, which leverages the Nasdaq by three times. As we mentioned recently, you don’t have to short this to get in on the fun as you can just trade the inverse version of this, which is structured to be short, and this is simply a better way to do it.

As we pointed out when we last discussed this, this is too sharp of a weapon to be used by those who aren’t looking to trade, and while this exploded up last Thursday, it also exploded down last Friday, and you don’t want to be stuck in this during 9% moves against you. When stocks really rebound, without knowing when to get out, you’re risking your life holding a 3X leveraged short fund that tracks a more volatile index like this one does.

He also suggests that investors consider low volatility funds to protect them in times like this, although an even better idea would be just to pay attention and not be willing to sacrifice a lot during the good times as a means to cope with our unwillingness to act when we clearly should.

Overall, Mezrich does show us that he has a mind far more open than just about anyone out there, and when you do, the alternative courses of action that he speaks of will easily appear. We still need to measure the effectiveness of the ideas we come up with when we open our eyes more, as well as look to discover how to best proceed with the ones we choose, choosing based upon merit rather than just bad habits.

Quant analyst Savita Subramanian of Bank of America uses her skills to flesh out opportunities I the income sector, focusing in particular on the dividend component of stocks. This serves as a great example of how we not only want to be looking at the numbers but looking at the right numbers.

We always want to try to keep an open mind rather than toss this very idea based upon how people use it as a one eye blind approach to investing. Perhaps a quant can at least make more sense of this, and that would be a worthy accomplishment indeed as the challenge here is great.

We knew that a quantitative analyst isn’t just going to tell us that we have to ignore the overall numbers here, the total return of these investments, and as stupid as just looking at dividends and ignoring capital losses should appear to be to us, this is what we see with this strategy.

Subramanian does realize that this does matter, but she claims that higher dividend stocks have been more stable. While that is far from convincing us that we should ever choose such a thing, to choose to lose less money over more money, this at least might suggest these stocks have been more defensive lately, even though they are far from defensive normally.

It turns out that these funds have fallen even harder than the market lately. The Vanguard High Yield ETF is down 21% year to date, while the S&P 500 is only down 16%. Year over year, the dividend ETF is down 13%, compared to the 3.5% that the big index has lost.

If we are a quant, it’s the numbers that always matter, and these numbers do not speak very well about this fund. She may have drunk a more watered-down form of the drink that income investors are under the influence of, but only being half-drunk isn’t much to be proud of.

Subramanian does at least discuss the “yield trap,” where their fundamentals decline to the point that they need to cut their dividend, sometimes drastically, but there’s much more to worry about with these stocks than just this, unless of course that’s all you look at.

These funds famously perform terribly in all conditions, relatively speaking that is, but it’s all relative as one option that completely beats another should be something that we should desire, and we should never wish for lesser outcomes.

Quantitative analysis seeks to provide meaning to situations through analyzing the numbers, and an example of this would be how a quant might approach the coronavirus data we have. The ratio of mild to severe cases has been growing, where we’re now up to 93% mild. While new cases have been accelerating, severe cases have been in decline for quite a while now, since February 18 in fact, when we started to freak out. This can only mean that the threat is diminishing. You have to look at the right numbers to get the real story though.

The only reasonable explanation for this is that we have expanded the number of cases discovered by doing more testing of those not critically ill, where those who are really sick have always commanded it. The world has now gone mad over this statistical misrepresentation of things getting worse, as we should not be afraid of the mild verson and need to worry about how many people are getting sick enough to determine how the real threat is progressing.

Given that new cases have grown by 52% since February 18 but serious cases have declined by 53% over this time, we get to view the real story behind the numbers. If the threat were indeed increasing rather than decreasing, the number of serious cases must increase in turn because if conditions were really worsening, we would see both the number of serious cases and the number of deaths go up.

The deaths will always go up nominally of course, but the serious cases must as well for the threat to go up, as more and more of us reach that state in a situation that is supposed to be escalating at least. The death rate has gone down by 5% over this time, which we would also expect from this dilution through extending the threshold of testing. It’s not that the number of critical cases has been reduced by more people dying, it can only be from less people getting critically ill among those recently infected. This illusion is courtesy of our statistical sample escalating, not the danger, and quite the contrary.

Numbers can be important indeed in guiding us away from inferior conditions and toward better ones, but only if we look at the ones that really matter, with stocks as well as in life.

The Fed going all in on Sunday night by putting rates down to zero and preparing for $700 billion more of quantitative easing sure makes the game more interesting. Trump is finally happy and expects the stock market to rebound, but with the market gone insane over this virus, we need to make sure that our seat belts are on tight because the ride down may be far from over.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

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