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

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by Tyler Durden
Wednesday, Jun 14, 2017 - 17:01

Authored by Seabreeze Partners Management's Doug Kass,

If you haven't read my opening missive, please do, as it's important.

This column extends the conversation 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 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.

Think about that. 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. The 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."

Listen, Luddites, 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? (e.g. last week: Comey testimony, UK elections, ECB, geopolitical uncertainty, Qatar, FANG flash crash, etc.)."

-- Marko Kalonovic, JPMorgan's head quant

I vividly remember episode 40 of Twilight Zone entitled "A Thing About Machines." (Here is a clip of the episode)

Originally aired on Oct. 28, 1960, it's the story of a repairman who pays a house call to Bartlett Finchley, who is having trouble with his television's reception. Finchley is an ill-tempered and lonely gourmet magazine critic. He abuses machines in his home and he is as inept with human beings as he with the machines, which he concludes are conspiring against him.  

Though Finchley is seen as paranoid by many, eventually every machine in the house (including his car) turns against him: 

  • His typewriter types out the message, "Get out of here Finchley."
  • A woman on the television speaks the same message.
  • His electric razor rises menacingly in the air and lunges at him.
  • An unplugged telephone has a voice that speaks the same words as the typewriter. 

Finchley drinks a bottle of liquor and passes out. When he awakes, the machines in the house tell him to get out and the razor pursues him. He runs out of the house and is chased by his driverless car, which winds up pushing him into his pool. 

Sinking to the bottom, Finchley drowns. When the police pull him out, they can't explain how he could sink to the bottom when not being weighed down, as normally a body would float, nor could they explain the car near the pool. 

Listen Luddites, for the stock market, too, it's a thing about the machines. 

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 (e.g., 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, who is quoted at the top of this piece and again here: 

"... 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, based on Kalonvic's analysis: "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 read this important note from JPMorgan's head quant (hat tip to Zero Hedge) in order to 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. 

This is not my Grandma Koufax's stock market.