Feedback Trading's Hollow Victory

My friend, and part-time drinking companion, Macro-Man, whom I respect much, flippantly employed the title late last week of "Will the last one to leave please turn out the lights?" in regards to the spate of Hedge Fund blow-ups. I say flippant because I daresay this doesn't reflect the actual situation. For every Drake, Carlyle, Sowood, Amaranth, Peloton, Go, and yes and of course merely brow-beaten like SocGen, there is a Winton, Citadel, Brevan, Ospraie, Caxton, SAC or Tudor, or increasingly a bevvy of non-fundamental systematic investors popping cork on the vintage stuff as they do their victory lap. Not to say that there is a winner for every loser - for this is fallacy: there isn't. But you see, I am fascinated by the structure and nature of market participants - particular the more active traders who, in frenzied turnover, increasingly make up a greater percentage of daily value traded. And cannot help wonder whether the winners and losers are merely "the right" and "the wrong", respectively, or whether market Darwinism is not in the process of yielding something more pernicious that a winnowing of the most feeble investors and less-adept game-players.

Imagine for a moment that the winners and losers have, in addition to being right or terminally wrong, archetypical investment styles associated with them. Imagine that the future health of the market (at any point in time) is dependent upon the continued representation of diverse investor phenotypes. Now go one step further and imagine that Darwinian natural selection has wiped out an inordinate amount of the contrarians, be they the value-players, real short-term liquidity-providers (e.g. jobbers, market-makers, block-desks, independent floor traders or once-successful contrarians like Alliance Cap;s Alfred Harrison), en masse representing substantial risk capital.

Is this problematical? Perhaps not if the successful, i.e. those that were "right", were randomly victorious, OR if they were "right" on the basis of idiosyncratic but ephemerally-correct fundamental analysis that, next time around, would amongst the prior winners, yield equal amount of losers. But, as a thought-experiment, imagine what might happen if they [the winners] were predominantly of a single species, or reasonably correlated investment style or approach, be they trend-followers (CTAs), or momentum-oriented, systematic-macro employing price-based quant models for short-term predictive purposes, or order-sniffing micro-structure strategies - all which share traits that arrive at similar positions, for similar (essentially non-fundamental) reasons. What would this mean for markets, price behaviour and volatility, and the relationship between shorter-term prices and their more fundamental longer-term equilibrium?

Getting to the point, might a meaningful shift in the balance of "styles" pursued have a dramatic impact upon behaviour, elevating volatility, diminishing liquidity (in the market sense of size at a price), and elongating trends and their departures from longer-term fundamental equilibrium prices where real supply meets real non-speculative demand?? More to the point, hasn't this been happening in a almost continual process of natural selection over the past six years, accelerating recently with the rapidly bifurcating fortunes of all manner of traders, investment managers and hedge funds?? What is the practical result of a market with a paucity of liquidity providers and more value-oriented investors willing to warehouse risk, contra the prevailing trends? Alan Brown, Investment Head atop $280bn at Schroders in London said o Bloomberg:

I am struck by two thoughts. There are an awful lot of assets out there that are offering very attractive terms. On the other hand, we have an entirely dysfunctional market at the moment where marked prices are notional and if you want to trade, the bid falls away from you dramatically..."

He means liquidity withdrawn due to "The Credit Crunch", but the same dynamic might result from a rapidly changing balance in participant makeup where those with feedback-oriented strategies rule the roost, and amplifying the smallest of signals, reinforcing oft-divergent trends from the underlying market, and in the process disintermediating real buyers and real sellers, raising price volatility and uncertainty, both negatives for markets and economic efficiency.

Now we might also sensibly ask whether the survival of the fittest might produce better economic outcomes, for ridding markets of feeble should be an unmitigated good, no? To answer this, we need to ask "why?" this has come about at all, i.e. why has feedback trading has trounced human judgment? . The "why" has probably been globalization, poor policy extremes in US (fiscal, monetary and energy) & China (international and domestic monetary and trade) , and GCC, as well as the lack of policy agreement and coordination amongst nations. As for whether such natural selection is "good", I have a suspicion it is not. While such mimetic and feedback-oriented strategies still rely upon "the signal" from somehwere, what if at the source, "the signal" or impulse is manipulative or predatory (remember Amaranth?) in origin, or worse sheer fad or folly (remember E-hemorrhoid.com??) ? In reality, most commodity markets and exchange contracts are small in relation to the financial economy, and so are ripe for manipulation and abuse by large, clever, or large and clever particpants' size and relative market power. If the sources determining market price and initial impulse were on the other hand real supply and demand, then perhaps the amplification of such allocative outcomes would serve to create signals and move prices towards longer-term equilibrium faster, thereby promoting efficiency. But where, for example, in Crude Oil, Wilbur Ross proffered on Thursday, more than 30% of trade is pure financial leveraged spec, much which is the sub-category type described here, one would have good reason to view their presence in regards to market efficiency, as, in the words of Donald Rumsfeld, "rather unhelpful" for a speculative collapse might, yet again , send alternative back in to the realm of the less-than-economic faster than a less-high but more stable price regime might accomplish.

Finally, one might ask the logical question: what sort of nightmarish doog-chasing-his-own-tail market regime follows such outcomes when the feedback traders - now dominant - are destined to trade amongst and against themselves in a nightmarish hell (for systematic traders) of failed breaks, large reversal gaps, that is perhaps the inevitable rent for the extended runs of the present, after which ummm errrI guess Citadel will own The World??!?!