(Video): Scott Patterson Tells Us the History of HAL9000 in "The Quants"

Since blog inception summer 2007 I had often made reference to "the supercomputers" and their growing effect on what I was seeing in day to day trading.  Ironically August 2007 - the month I began the website - was the first time their footprints really rocked the markets, even as stocks went on to make all time highs in October 2007.  Some of the stocks I was in, such as CF Industries (CF) - among many others - were experiencing the type of volatility I had never seen before.  Later we found out that the "quants" were experiencing some major malfunctions which were leading to these crazy movements.  See this piece we had mentioned a few times on the website from Aug 13, 2007: Pack Mentality Among Hedge Funds Fuels Market Volatility.

I now see "HAL9000" referenced in widespread usage across the financial blogosphere in association with "program trading", "algorithimic trading", or "high frequency trading".  I am going to take credit for that trend setting word association until proven otherwise, since that's what we began "affectionately" calling these mad microchips in 2008. (maybe even 2007, would have to dig back some 5500 posts)

Whatever the label, I was definitely not the only one to notice their outsized effect... noted hedge fund manager Doug Kass, along with Jim Cramer were speaking of their heavy influence about 2 years ago as we were about to head into the worst of the financial crisis.  Now what I did have much grasp about at the time was "high frequency trading" and "flash trading" - ZeroHedge took the lead on exposing those subsectors of "quant trading". a bit later in time.  But all these styles frame a mosaic of a very different market than we had even 5 - 10 years ago.  Some estimates say these computers now make up 70% of every day's volume.  Despite holding only a fraction of assets that mutual funds, pension funds or more traditional hedge funds own - they are the marginal buyer and mover of markets in my opinion.  As I wrote in [Aug 6, 2008: Cramer - Quants and their Machines]  Please keep in mind I wrote these things AHEAD of Fannie, Freddie, Lehman, AIG et al.

For those who have been around a while you know I constantly refer to the "supercomputers at the hedge funds" controlling things or at least being the marginal decider of prices. As a participant in markets for a while now I have to say some of the things we're seeing the past year or so are beyond compare.



My thesis has been the quantitative hedge funds really have changed the nature of the markets and trading. The most successful and famous is Renaissance Technologies, led by Jim Simons. The track record of success there has been fantastic, and it's all computer driven. Success begets copy cat behavior - and a flood of funds trying to replicate the grand chief have been born. Hence when I refer to "algorithms" dominating trading, I am speaking to this bevy of pooled capital, all doing (or trying to do) almost the exact same thing and taking stocks farther (both higher and lower) than makes any logical sense. And this, in my opinion, is simply crowding out people who use fundamentals or logic. The machinations of August 2007 really was the first time this hit me in the face as I was seeing action that were in no way explainable by any reasonable data point. Much of it was "liquidations" i.e. hedge funds over levered and much like an individual investors gets a margin call - so did they. So they had to sell what they could, not what they wanted to as many hold esoteric positions that had no market (hedge funds don't just own simply stocks and bonds). So they sold off the liquid parts of their portfolios. And once a selling begins, a waterfall effect hits as technical conditions are triggered in computer after computer throughout New York City (and in fact the world) and you get this cascading effect.

I am of the belief that eventually something will go very wrong in a system like this; in much bigger scale than August 2007 or some of the cascading selloffs in 2008.  "They" assure us they provide liquidity.  But with some of these computers doing 1000s of trades a second, and so many quants doing the exact same thing - all set to hair trigger off each other, it is very easy to imagine a scenario where Oct 19, 1987 happens not in hours but minutes.  Hopefully I am very wrong on this - but I certainly don't take any solace in the assurances from either the quants themselves or their regulators (who are either asleep at the wheel or captured), that it can't happen.   These are the same groups of people who assured us they had everything under control and all risk was arbitraged away pre 2007.  There is no way to assure anything with a disparate electronic ecosystem spread over countless desktops storage facilities.
 
With that said, Yahoo Tech Ticker has some interesting videos out with a Wall Street Journal reporter who has written a book on the subject called "The Quants".  For those of you actively engaged in the market, or who grew up learning in a whole different era I believe it's quite important to become familiar with the changing face of the market.  Some more recent pieces within the last year:

1. [Jun 18, 2009: Joe Saluzzi Comments on HAL9000]
2. [Aug 28, 2009: WSJ - Meet Getco, High Frequency Trade King]
3. [Sep 4, 2009: Meet Optiver, High Frequency Trading "Friend" in Oil]
4. [Dec 3, 2009: Geeks Trump Alpha Males as High Frequency Trading Takes Over]

 
I also believe this is why technical analysis is becoming more and more of a dominant theme in the stock market - as computers processing relationships by the 1000th of a second aren't exactly reading profit & loss statements, or balance sheets.  As I also wrote 2 years ago:
 

We are just mice dancing between the elephants of capital and their super computers.

 
Last point, if you are a believer in the Plunge Protection Team ... Mr. Larry Summers spent a few years at DE Shaw, a quant hedge fund shop in between his White House stints [Apr 6, 2009: Larry Summers - No Conflict of Interest; He Pinkie Swears] ... so if anyone knows how to milk the system to spend the least amount of taxpayer money to get the market going "where it should go", they have the right man.
 
1) Rise of the Machines - How "Quant" Trading Triggered the Credit Crisis
 
(5 minute video)
 

 
Greedy CEOs, bad regulators, short sellers, debt-happy Americans, and politicians of all stripes have been blamed for the great credit crisis of 2008.

Add another name to the blame list, says Scott Patterson, staff reporter at The Wall Street Journal: Quants, which is shorthand for the elite mathematicians and computer experts who've come to dominate trading in recent decades.

As chronicled in Patterson's new book "The Quants", the runaway success of computer-driven trading in the 1980s, '90s and early '00s led to complacency and hubris, ending in near total disaster for Western-style capitalism.

"Mathematical constructs" such as CDOs, derivatives and mortgage-backed securities "caused banks essentially to implode," Patterson says, placing blame for the credit crisis squarely on the quants.

Recalling the 1987 crash and the 1998 Long Term Capital Management saga, Patterson notes the 2007-09 credit crisis wasn't the first time quant creations nearly blew up the financial system. Nevertheless, the CEOs of big Wall Street firms had little or no idea what their own proprietary (or "prop") trading desks were doing, just that they were generating huge profits - until suddenly it all went wrong.

Even more frightening, Patterson says very little has changed in the aftermath of the market's latest near-death experience.

"All of Wall Street [trading] is really quantitative - there's very little that's not," he says. "When you peel the onion you're going to find a math guy sitting in the midst."
So what chance do "Mom and Pop" investors have against a room full of PhDs totally focused to finding market opportunities? Not much, Patterson says, holding out little hope than any of the proposed regulatory changes will really change the game, or the odds.

2) Revenge of the Nerds: The New Masters of the Wall Street Universe
 
(5 minute video)
 

 
In his new book "The Quants," our guest Scott Patterson details how a new crop of mathematicians and computer scientists outsmarted Wall Street's old guard -- the "gut traders" made famous in Michael Lewis' classic Liar's Poker.

Who are the quants? "They were the math nerds who got straight As" in school, says Patterson, also a staff reporter for The Wall Street Journal.

During the '80s, from Newport Beach, Calif. to the outskirts of Boston, these "nerds" were fine tuning math-investing computer models at home, when they realized they could cash in on Wall Street. Gradually, the quants began to outsmart the old-school gut traders, Patterson explains. By the the late '90s, they had become the new kings of Wall Street, but "they took the fun out of Wall Street," he tells Aaron in the accompanying clip.

Using sophisticated algorithms and computers, quants like Ken Griffin, Jim Simons and Peter Muller set up what would become wildly successful hedge funds.

Computers, not human emotions. But a funny thing happened in 2007 and 2008. The algorithms and computer models failed to factor in the market's human, emotional element; a market in panic doesn't care what the models say "should" happen.

Plus, unlike the gut traders of the '80s, the quants discovered a new repercussion to their fancy investing strategies: If you bet wrong in a new, connected global economy, you could damage the entire global financial machine, as the 2008 credit crisis proved.