Monday, January 25, 2016

"How human traders will beat the machines"

Intertemporal arbitrage?*
From the Financial Times:
Advancement of computer-driven trading systems may sow seeds of their eventual obsolescence
When Garry Kasparov sat down to play the IBM Deep Blue computer the Russian chess grandmaster believed he had discovered a strategy to turn the machine’s greatest strength into a weakness.
Deep Blue relied on being able to compute a vast database containing hundreds of thousands of chess games played by past grandmasters, meaning Kasparov was not simply playing one supercomputer but in fact taking on the amassed knowledge of many of the strongest players from history all at once.
But to be able to make use of large parts of its database, Deep Blue required its opponent to play like a typical grandmaster. If Kasparov was to intentionally make a bizarre opening play rarely seen in high level games the computer would have vast parts of its database rendered useless, as it would have fewer games to reference, and the human could regain the upper hand.
Kasparov’s “man verses machine” struggle with Deep Blue and his eventual defeat is a frequent refrain in discussions about the future of financial trading, and the likelihood that ever advancing technology will render the human fund manager obsolete.
Many human investors are enduring a miserable start to 2016 as stock markets and commodity prices have slumped. At the same time some trend following computer-driven hedge funds have made double-digit returns during the sell-off. Is man once again on the verge of being trumped by the machine like the Russian grandmaster? The answer is no. Here are three reasons why the best human investors are likely to be able to beat the “bots” for a long time to come.
First, human investors can follow Kasparov’s strategy and seek to use the strengths of algorithmic trading programmes against them. To paraphrase Oscar Wilde, trend-following hedge fund computers know the price of everything, but the value of nothing. This means human investors who focus on value over the long term, rather than price trends, should always be able to profit.
Hedge fund computers rely on their analysis of millions of data points from past market movements to use this to predict how markets will behave in the future. Broadly speaking, when any large market moves in one direction for a period of time the trend following computer will be able to profit from this, as many have done this month.
These computers however are not investors in the true sense of the word, but semi-automated trading bots seeking signal within market noise. Their models analyse price data, rather than creatively assessing, for example, how accurately a share that represents fractional ownership of a real business reflects the present and future value of that business....MORE
*I know I think about time-shifting more than the the average person.
Okay, truth be told, despite a predilection for really fast 'puters I obsess about outsmarting the machines.

I mean what normal person types this headline "'Facebook, Google, and the Economics of Time' (FB; GOOG)" and follows it with this opening sentence: "Although this story is not about intertemporal arbitrage I'm sure that's the first thing some of our readers thought of."

Or gets giddy with "Intertemporal Arbitrage: 'Winning Big by Playing Long-Term Trends" (CNI; PNR)?
So be it.

See also 2013's "UPDATED--The Economist On How the Commodity Quants Lost It":
...The bolded bit points up one of the failures of the fund managers.They get paid to figure out the intertemporal arbitrage, a fancy way of saying the task at hand is to understand the time period that gives the fund the greatest advantage versus the market..  
The classic example is the individual investor realizing that he can't compete with HFT and looking at longer than nanosecond time periods. This opens up the possibility of not just not-competing with the traders with the lowest latency but of taking advantage of mispricings caused by their behavior. This is exemplified by one of Buffett's baseball metaphors (he has quite a few): 
 "In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw a ball right down the middle; and if it's General Motors at 47 and you don't know enough to decide on General Motors at 47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss."
The point is, you don't have to be at the market every second You are afforded the luxury of just waiting for the perfect pitch. 

Now for a fund manager it get's tricky writing the quarterly report and saying "We didn't do much in Q3, we're waiting for Mr. Market to give us the high hanging curve ball" but if you've been honest with the investors that the tactic you've pulled from the toolbox is akin to the military's hurry-up-and-wait sense of time it is doable.

As a side note anyone who considers a move that is measured in weeks to be a trend is nuts. A trend is John Templeton going into the Japanese markets at 2 times earnings and catching a 40-fold move 1965-1989....