Until the Quant Selling's Done, The Beatings Will Continue

The drop in the stock market isn’t done yet…

During my twenty plus years on Wall Street, there was one thing that was certain… every day on the job would be different. And to me, that was one of the biggest appeals of the job. Every day, I was afforded the opportunity to observe and learn. I knew that by paying close attention, I would be afforded the opportunity to employ that knowledge down the road, passing it on to other investors. That way, I could spare them from making the same mistakes.

One thing you learn quickly is that money managers hate economic uncertainty. Because when they don’t know what the growth outlook will look like, it’s harder for them to get a handle on goods demand. If that happens, estimates for corporate margins then become questionable. And without reliable estimates, it’s hard to place a fair-value multiple on a stock, making it difficult to buy anything.

And when situations like that arise, institutional investors can be quick to sell first and ask questions later. That way they have money to re-invest when the dust settles, rather than doing nothing, and potentially dumping assets at lower prices.

Well lately, the economic environment is increasingly being questioned. With the on-again/off-again tariff statements from the White House, Wall Street’s uncertain of what’s going to happen. One day, they’re buying stocks, thinking the tariff threat has subsided. Then, later that same day, money managers are dumping stocks because levy threats are back.

After having that happen multiple times over, investors start to give up. They decide that instead of trying to buy good stocks that look cheap, it’s better to save their money and wait. However, when that happens, stocks start to drop, and trends begin to break…

Well, as I warned earlier this week, the S&P 500 Index was in danger of breaking down through its 100-day moving average. And if this happened, it could cause algo-driven hedge fund sellers to pile on, pushing stocks even lower.

Based on last night’s close, that level was breached. And if something doesn’t change investors’ minds about the economic outlook soon, they’re unlikely to rush back into stocks. That means the momentum selling could grow worse. That would mean the S&P 500 may need to test the 200-day moving average at 5,715.

But don’t take my word for it, let’s look at what the data’s telling us…

The investment strategy we're discussing is most commonly associated with Commodity Trading Advisors ("CTAs"). For those unfamiliar, they’re hedge funds that use algorithms to help them invest. That means they rely on electronically driven buy-and-sell triggers to invest. Because a computer model is making the call, CTA funds don't try to discern whether a buy or sell order is the right or wrong idea for the moment – they simply execute.

CTAs manage roughly $340 billion in assets. But, because they're hedge-fund managers, you have to consider that money to be long and short. This means they could have more exposure than what their asset size shows because the short and long sides of their books offset one another.

In addition, CTAs are using leverage to help improve their returns. So, when you consider that leverage could be in the neighborhood of four to five times assets, that $340 billion number has an impact of roughly $1.5 trillion to $2 trillion.

The investment strategy was designed to take advantage of gradual moves upward or downward in the markets, and not so much for markets experiencing rapid shifts. CTA buy-and-sell indicators are based on the markets touching key trigger points. So, for instance, as the S&P 500 makes new highs on the way up, CTA models tell the funds to buy more. And on the way down, as we make new lows, their models tell them to sell more.

Late last summer, in the buildup to the Federal Reserve’s first rate cut announcement, Wall Street was increasingly optimistic about the rally potential in the Treasury market. Investors anticipated 100 basis points worth of rate cuts by the end of 2024 and another 100 basis points in 2025. So, the potential for yields to drop would mean a rally in bond prices.

As a result, CTA models told them to load up on bonds. So, they did… heading into the Fed’s policy meeting last September, those funds were as long U.S. Treasury bonds as their models would allow. And because they’d spent so much of their money snapping up those assets, they had little exposure to stocks. According to brokerage firm Goldman Sachs, it was close to zero.

But in September, that all started to change. Once the Fed cut rates, quant models received the signal to sell bonds and start buying stocks. So, they started to execute. Between mid-August and last week, CTAs bought up roughly $150 billion worth of stocks and the S&P 500 rose just over 13%...

Then, last week that all started to change. Money managers became increasingly worried about the growth outlook, and the potential for a government shutdown. So, they started hedging their books. But as they pulled back from investing, the process placed downward pressure on the markets.

On Monday, the S&P 500 closed below the 50-day moving average. That marked the first trend break since August. Goldman warned the change would trigger more selling. It stated that a drop in the S&P 500 for the week would trigger $12.6 billion worth of selling. Not only that, but if the market is down over the next month, the sell tally could pile up to almost $60 billion. Based on yesterday’s close, the S&P 500 is down just over 2.5% this week. In fact, the drop now means the gauge is negative for the year.

So, like I said at the start, Wall Street hates uncertainty. Right now, with the back on forth on tariffs, coupled with the potential for a government shutdown, money managers aren’t sure how the situation will play out economically. As a result, the environment is discouraging them from investing. That means that unless Washington does more to answer these questions, stocks may need to test the 200-day moving average to encourage steady institutional buying.