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Does News Move Markets….Sort Of…Maybe…Well No Actually

I was chatting the other day with someone who was having trouble with their trading system. Their approach was based on trading news events. Such a plan is predicated on the notion that news events move markets in certain ways and whilst this movement might not be wholly predictable it will at least generate some form of activity. Such a trading system has a single giant assumption – that news and news related events move price. If this maxim does not hold up then the system is a bust.

It has been sometime since I looked at this question and I had a vague recollection of research done in the 1980’s that looked at this question and found that news as a source of trading ideas was a bust. So armed with the dimmest of memories I went looking through my archive and found what I was looking for. David Cutler, James Poterba and Lawrence Summers produced a working paper titled What Moves Stock Prices for the Department of Economics at MIT in 1988. This paper looked at the 50 largest single day moves in the US market since World War Two – I have included the events from the original monograph below.

Event 3

If you take a cursory look at the events above you could argue that news events do move markets. However, there is a glitch in that some movements defy explanation – there is simply no event that can be seen as a casual trigger for a market move. Cutler et al stated that news events could really only be useful as an agent for movement in about half of all cases of the variance in stock price movement and in my world half is a fluke.

The interesting side issue with the work of Cutler et al is that it puts another hole in the Efficient Market Hypothesis because stock price movements according to the EMH reflect the assessment of investors to new information. If markets move without the the addition of new information to the system then something else is happening that is not explained by the EMH. And it seems in the case of broad brush analysis as performed by Cutler that prices move without any significant input.

This initial work has been expanded upon by Ray Fair at Yale University who looked at outsized movements in the S&P500 futures contract. This new work had much greater granularity to it in that it looked at five minute data, something that would have been difficult in the original work by Cutler and crew simply because the available technology would not have allowed it. Fair compared what he defined as big movements with news items emanating from the Dow Jones News Service, Associated Press and New York Times. The upshot of this investigation seemed to be that the majority of large events have no news based driver. They were only able to attribute a news item to 69 of the 1159 big moves that were examined. Recent  flash crashes seem to support this notion of significant market moves  occurring without a notional driver.

So we come back to the original assumption that news events drive markets and that these moves offer opportunities that can be traded. It would seem on the evidence available that this notion is false.

No Man Is An Island

So said John Donne and the same is true of markets. One of the most fascinating features of trading is that markets at times they display interesting interrelationships and that these relationships tell you something about the underlying emotional state of the market. Below are three markets I am currently involved in and all seem at this point in time to be telling a story about how the market is currently coping with a President – Elect who seems to have the IQ of a trout and the stability of a slinky falling down Mt Everest.

Markets

As  personal disclaimer I am currently long gold, short the USD in various iterations and my short term Dow system just threw me out from my last long position. So this is my story so it reflects my internal bias. What is interesting is that the Dow didn’t power through 20,000. I remember when it hit other “significant” numbers and it just burst straight through – there was no prevarication or hesitation. Yet at the same time the Dow paused gold began to move up and the USD Index began to move down. Whilst is is interesting to try an assemble a narrative from this – it is easier to simply trade the charts and let others build a narrative as to what they mean.

As a final point it is worth looking at how a few major markets have performed YTD – as you can see precious metals seem to be doing a fair bit of heavy lifting.

YTD

 

Apparently I am Not Going To Die

As a regular user of sauna’s to manage post workout soreness I am heartened by this headline.

Sauna NewsSource – Healthiest Blog

Statistics And Elections

One of the more annoying things about the US election;as if it were at all possible to list all the annoying things in one sopt is the inability of journalists to understand basic statistics. Consider the
graphic below which I snipped from the site FiveThirtyEight

poll

Most are interpreting this as a lock for the Clinton campaign, after all it has to be because 69.9% is larger than 30%. In talking about probabilities it is often instructive to use examples that people might be able to relate to. Imagine you were playing a game of Russian Roulette. Its a simple game were you load a single round into a revolver and spin the chamber, you then point the gun at your head and pull the trigger. You have a 1/6 chance of blowing your head off. Lets assume that you are playing a more advanced version were you load two rounds separately into the gun and spin the chamber. The odds of blowing your head off is now 2/6 or 33% – this roughly equates to the chance above of a Trump victory.

The question you need to ask yourself is do you feel confident enough on the basis of this change in probability to pull the trigger. My guess is you dont, even if a 66% chance of not blowing your head off is higher than a 33% chance of blowing your head off.

Starting Dates

When I was banging on about EFT’s last week I made the point in passing that when you are looking at trading systems that the start date is everything and it is the point at which most of the fudging of results occurs. As an example I took a hypothetical passive system and began to change the starting date of the system to highlight this problem. The chart below shows a series of start dates counting down from ten years ago to today. So if I had started this system and traded it for ten years its annualised return would be 3.6%. Whereas if I had started the system seven years ago my annualised return would only be 1.1%.ReturnsAs you can see changing the start date changes the annualised return that is generated by the system. The worst returns have occurred in recent times with the best being five years ago. It doesn’t take much to work out which you might include in your marketing material if you wanted to cast yourself in the best light. This problem can occur on even shorter time frames such as moving the start date from one month to another.

The problem is also has nuance that catches the unwary; annualised returns are simply a nonsense measure when viewed in isolation because of problems with the construction of averages. For example imagine you invest $100,000 in a fund that in the first year generates a 100% return and then in the second year losses 50%. How much have you made, if you were to a look at the yearly average return you would calculate that 100%-50%/2 = 25% and the fund manager could rightly claim to make this average figure. However, your true return which is the only one that matters is zero.

True returns are given by an equity curve with as much data as possible – this gives you some idea of the trajectory of an account under a variety of conditions. This is then supplemented by looking at the drawdown curve of the system to give you an idea of how rough the ride. So for our hypothetical system above if I take the start date of 10 years ago I get an annualised return of 3.6% but a maximum drawdown of 44.5% because the system is caught by the GFC and being passive it takes no defensive action. Yet if I take our preferred kick off date of five years ago I get a drawdown of only 20.8%. So my system at this point has nearly twice the annualised return and half the drawdown.  Yet the ten year figure is the more complete since it also includes a global shock so it shows the true performance of the system whilst under pressure.

This leaves us with the problem of how to deal with this in a real world situation where this data might not be forth coming. Fortunately we can reduce this problem to a simple rule. If a system does not immediately show a drawdown or has a smooth equity curve something is not right.

Quants: The Alchemists of Wall Street


 

Noise Versus Information Versus Decision Making

One of the growing problems I have noticed over the years with trading is the increasing amount of data that is available to traders. In the good old days we had the reverse problem, getting any information was difficult. Even finding out the closing prices in the US could be tortuous. The internet has completely reversed this problem with not only every world market available to traders at an instant but the powerful analytics of tools such as Bloomberg terminals have begun to filter down to the masses. This presents a unique problem because increasing the amount of information does not increase the fidelity of decisions being made. As an example I got bounced the graph below this morning  for comment.

surpassSource – Dave Wilson

The graph shows that US pension funds are increasingly beginning to rely upon cash as a means by which to fund their obligations. The interpretation that was put to me was that this meant that Pension funds were becoming disinterested in equities as a growth or funding mechanism for their obligations. The extension of this was that there was less and less cash being dropped into the market and the market would respond by falling. This is a valid narrative but a narrative is only a story used to explain historical data. An alternative narrative might be simply that it reflects the ageing population of fund members and as the demographics of the fund shift so to does the strategy that funds that. However, that too is merely a story.

The point that troubles me is that that this information conveys in some a strategic advantage when in fact it is simply data and this is the issue that bedevils traders – sorting data from information. However, there is a secondary issue and that is whether the information you are receiving in some way adds fidelity to your trading decision. It doesn’t matter whether the information is of a macro nature or is perhaps more tactical in nature, the overwhelming question is whether it adds to your decision making. Decision making is a bounded utility, it is bounded by time, the quality of the information you receive and your cognitive ability. These can never be infinite but implicit within this is that decision making is a somewhat quick and dirty process that has to managed and the information upon which you are making a decision has to be managed. This is why models and systems tend to perform better than people do. More information does not make for a better decision. As a real world example consider the case of the heart attack model developed by US Navy cardiologist Lee Goldman. Goldman built a simple visual model that enabled particularly submarine medics to decide whether a heart attack was taking place. As you can imagine getting someone quickly off a submarine is not an easy task. This model might have sat in relative obscurity if it had not been taken up by Cook County Hospital in Chicago. Previously diagnosing a heart attack with the hospital had relied upon a battery of tests (data) combined with the opinion of whichever cardiologist was on duty. Short of funds and looking at ways to streamline treatment options the hospital implemented Goldman’s simple model. There was naturally concern that the outcome for patients might be compromised by using such a simple linear model with only four metrics. Intriguingly health outcomes for patients didn’t change. More data or noise did not mean better outcomes.

So before you go plastering your chart with indicators each with supposedly magical ability or you fork out for a Bloomberg terminal ask whether what you are adding actually adds to the fidelity of your decision making or whether it is fulfilling another need.

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.