VTI - The Markets Speak: Understand The Herding Effect

2023-06-15 09:19:22 ET

Summary

• The herding effect in financial markets is strong.
• Keynes famously referred to the herding effect as animal spirits—literally the natural tendency of investors to act like a herd of animals.
• The natural herding effect of investors is strengthened by Federal Reserve gambits to inject and to withdraw liquidity from the financial system.

The influence of herd behavior on financial markets is significant. This concept, termed "animal spirits" by the celebrated economist Sir John Maynard Keynes, represents the instinctual drive of market participants who often act collectively out of fear or greed, similar to a herd of animals.

Creating algorithmic models of this herd behavior is essential for index investors who aim to leverage the bullish trends in the market while steering clear of bearish downturns.

The inherent tendency of investors to mimic each other is further amplified by the Federal Reserve's gambits to inject and to withdraw liquidity from the financial system.

When the central bank forcibly adds or withdraws liquidity, it can outweigh the influence of economic fundamentals on the financial markets, leading to an exaggerated herding effect which often ignores economic fundamentals.

Market actors pay close attention to the overt policy decisions of the Federal Reserve. However, daily open market operations - the buying and selling of bonds - are equally crucial.

The central bank has a direct hand in influencing asset prices through their buying and selling activities conducted via their own trading desk.

These operations, undertaken by the Federal Reserve, contribute to establishing trends or sequential correlations in asset classes. By trading bonds, the Fed often further exaggerates herding behavior.

Furthermore, prevalent narratives surrounding technological advancements and societal transformation also stoke the flames of herd behavior.

Cases in point are the internet bubble and the subsequent crash in 2000, the financial crisis of 2008-2009, and the ongoing emphasis on revolutionary AI developments. Such narratives can cause multi-year booms and crashes, thereby reinforcing herd behavior in financial markets.

Over time, these factors collectively contribute to a powerful herding effect. Index investors' success or failure hinges on their ability to discern whether herd behavior is shaping a bull or a bear market.

Over time, the interplay of these variables creates the winners and the losers of the game. I use my Zomma Directional Algorithm to take advantage of trends created by the flow of investment dollars reacting to the interplay of these variables.

Algorithmic methods can often sniff out important statistical footprints that can help us determine when herding behavior is driving financial markets upwards or downwards.

The Zomma Directional Algorithm is designed to capitalize on trends that emerge from the investment flows caused by herding behavior.

Here's how to understand the visualization:

1. When line turns green, it signals a buy.

2. When the line turns red, it signals a sell and a move to cash.

Note: The algorithm is not designed to create short signals.

The herding behavior of the Nasdaq 100 ETF ( QQQ ) is fascinating. Right now, it is being fueled by popular narratives surrounding AI.

The Vanguard Total Stock Market Index ( VTI ) is also rising.

I have been telling my clients for years that they need to apply algorithmic entry and exit techniques to risk parity portfolios so they are not dependent upon bull markets in government bonds. Now they finally listen.

Although I wrote in 2020 that "[h]ousing computers and cell towers is becoming more profitable than housing people," the roll out of Elon Musk's Starlink system has the potential to completely change the economics of the cell tower industry. The market is taking notice. Why do you need as many towers if your phone service is coming from a satellite?

SBA Communications ( SBAC ) is getting hit.

American Tower ( AMT ) is also getting hit hard while the indices are climbing.

Crown Castle ( CCI ) has not been spared either.

Nvidia ( NVDA ) has been powering this bull market. Will clusters of its chips, as the hardware backbone of the AI revolution, become more valuable than human workers? Are Nvidia's chips the new labor force? The market seems to think so.

Keep your eye on the natural gas producers. It is going to take a lot of electricity to power all of that AI. It's hard to imagine a future in which Nvidia sells more chips, but natural gas producers aren't needed to supply those chips with more electricity. If Nvidia's chips are the labor of the future, electricity will fuel their work.

The First Trust Natural Gas ETF ( FCG ) is a good way to track this trend.

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