woensdag 14 juni 2017

Doug Kass: Not Even The Algo Creators Know What Is Going On

This conversation is about the problem with advanced market technologies and strategies a step further than most retail and institutional investors understand. Most people think of artificial intelligence and algos as simply executing logical rules programmed into them by humans, the same rules that the programming humans would follow if they were presented with the same data and data analysis. The algos and AIs are doing it in the same way humans have always done and would do, but at a much slower speed or perhaps not at all because of the very weak and distant relationship of some data items to other data items. The general belief is that algos and AIs are just "faster humans able to do a lot more calculations in a meaningful time frame". That may NOT be a correct characterization of some of the more powerful AIs that may be working in the markets. Of course, we don't know what AIs are working because there are no regulations requiring that machine decision-making accounts disclose and register as such a very, very big gap in regulation. True, AI and the related "machine learning" developments at the leading edge of such technology do NOT simply duplicate human rules and logic. Instead, while they may perform simple repetitive correlations initially on data as humans currently formulate that data, the more advanced machines go on to program themselves at successive layers, where the data being analyzed and correlated is no longer what we think of as data. Rather, it is often data artifacts created by the first layers in a form that no human would ever consider or has ever seen.
To put in a more street-level way, the first level creates ghosts and apparitions and shadows that the second layer treats as real data on which it assesses correlation and predictability in the service of some decision asked of it. AND a third and fourth and on and on are doing the same thing with output from each layer below it. The result of this procedure is striking and terrifying when the leading experts in AI and machine learning are interviewed. They admit that they have no way of determining what rules AI and machine- learning powered machines are following in making their decisions AND we cannot even know what inputs are being used in making those decisions.
# The creators have no knowledge of what their creations are thinking or what kind of inputs the machines are thinking about and how decisions about that are being made. Machines are inscrutable and, most terrifyingly important, UNPREDICTABLE. 
 We are not telling these AIs how to make decisions. The machines are figuring out how to decide to "make a profit" on their own and subject to no enforceable constraint. The resulting risk of "flash crashes", to lump all sudden and unexpected behaviors into a catchphrase, is unknowable but probably much greater than anyone even dreams. The machines have no fear of flash crashes or any other kind of crash. Such crashes might even serve their purpose of "making a profit." Be forewarned as last Friday's Nasdaq schmeissing may be a walk in the park compared to what may happen in the future.. The risks are much greater than most imagine. People need to understand this threat much better than they do. It needs to be better factored into the investment process. in the column entitled "risks.
# It's A Thing About the Machines; Let's consider that statement. In the last 20 years the VIX closed lower than 10 on a total of 11 days, and 7 of those days were in the past month. Think about that - over the past 2 decades, was the last month the most benign macro environment? (last week: Comey testimony, UK elections, ECB, geopolitical uncertainty, Qatar, FANG flash crash, etc.)." Marko Kalonovic, JPMorgan's head quant Throw away your fundamental analysis, your price charts, interest rates and economic growth forecasts, as the market has lost its moorings. It is no longer a pyramid of fundamental and technical analysis nor is it a response to changing investor sentiment. The ongoing multiyear changes in the market structure and dominant investor strategies in which quants, algos and other passive strategies (ETFs) have replaced active managers raise the same risks that Finchley faced 57 years ago. And the overwhelming impact of central bankers' largesse is the cherry on the market's non-fundamentally influenced sundae.
# As I have written: "The combination of central bankers' unprecedented largesse (and liquidity) when combined with mindless quant strategies and the enormous popularity of ETFs will, as night follows day, become a toxic cocktail for the equity markets. While we live in an imperfect world, we face (with valuations at a 95% decile on a number of metrics) a stock market that views the world almost perfectly." 
# Back to JPMorgan's Marko Kalonovic: "Some striking facts: to understand this market transformation, note that Passive and Quantitative investors now account for 60% of equity assets (vs. less than 30% a decade ago). We estimate that only 10% of trading volumes originates from fundamental discretionary traders. This means that while fundamental narratives explaining the price action abound, the majority of equity investors today don't buy or sell stocks based on stock-specific fundamentals. The next and perhaps just-as-important driver is, of course, central banks. With $2T asset inflows per year, central bank liquidity creates strong interest rate and policy sensitivity for sectors and styles. Low rates also invite investors to sell volatility." 
Everyone should understand how risk parity, volatility trending, stat arb and other quant strategies that are agnostic to balance sheets, income statements and private market value artificially are impacting the capital markets and, temporarily at least, are checking volatility. Last Friday's market schmeissing was the first shot across the bow. There will be many more of those Fridays....