/Outside the Box: My ‘greed-oriented’ algorithm is telling me to buy stocks

Outside the Box: My ‘greed-oriented’ algorithm is telling me to buy stocks

As the stock market responds to the coronavirus pandemic, should you buy U.S. stocks now or wait?

I created a machine-learning-based hedge fund that has managed institutional capital systematically for over 10 years. One of my “greed oriented” algorithms sees the plunge in the equity market

SPX, +6.24%

as a good time to buy, even as humans are gripped by fear. I agree, and suggest you consider taking its advice with a long view.

Algorithms offer useful, unemotional information during times of panic. While exact market bottoms are difficult to predict, the market will recover. The question is when, and how do I leverage the current opportunity to potentially see large returns when it does?

For humans, fear dominates in such situations. We are struggling to make sense of the economic and health-care uncertainties and the impacts of policy responses. We also know that the Trump administration will go to extreme lengths to prop up stocks during an election year, which could mean “socializing losses while privatizing gains” according to a quickly cobbled-together formula. Markets are gyrating wildly in response. World leaders appear to have dubious credibility, which adds to the uncertainty and fear.

In contrast, machines translate data patterns into investment decisions without emotion or regard to the underlying reasons creating them. The downside of algos in a crisis is they don’t understand that the world has changed. They don’t understand that the world has come to a virtual standstill. They don’t understand the implications of the various responses to stem the crisis. But on the upside, the greedy algorithm has no fear, but rather, can identify “volatile corrections” as buying opportunities that human investors may miss.

From a Darwinian perspective, the COVID-19 pandemic will probably wipe out significant numbers of leveraged enterprises not protected by the government. It will also present new investment opportunities, especially for companies that have plenty of cash and little debt.

A stark current example would be the Ford Motor Co.

F, -2.60%,

which has cash of $23 billion and a debt of $156 billion, versus Microsoft

MSFT, +6.26%,

with $134 billion in cash and debt of $87 billion. Unless the government bails out Ford, buying companies like Microsoft and selling companies like Ford is a good investment strategy right now. The stock market is full of such opportunities, but you or an algorithm must know how to interpret financial statements and analyze industries at some level of depth to successfully implement the strategy.

But what if you don’t have the investment expertise or an algorithm making these choices for you to identify the various opportunities? Should you just buy the broader market such as the S&P 500 index at the moment? The short answer is a yes, but you may weather losses in the short term.

In the last 60 years, the S&P 500 has seen a drawdown — the percentage retracement from the previous high —- exceeding 25% only seven times. The table shows that the average return from entry to the next high was over 37% on average if one entered on the day the index made a 25% drawdown.

Source: Vasant Dhar. Annualized return is based on monthly compounding.

The table shows the total returns of each trade, roughly 37.4% on average, and annualized returns averaging a respectable average annual return exceeding 15%, even if we ignore the unusually profitable trade of 1982 when Fed Chair Paul Volcker’s aggressive rate increases caused a brief recession followed by a rapid 90-day recovery to a new high. On average, the recoveries took several years, with the oil shock of 1974, the dot-com collapse and the financial crisis being the slowest, and with lower annualized returns of 5% and 7%.

The retracement as of the close on March 25 is a staggering 26.9% from Feb 19, 2020 when the S&P 500 hit its all-time closing high of 3,386.15. It has been the fastest-ever decline of this magnitude in the S&P 500 from an all-time high.

Considering how volatile the stock market has been in the last few weeks, it would be wise to stagger the entry points. Keep in mind, that the deepest drawdown in the S&P 500 was roughly 58% during the financial crisis, so the stock market’s decline could continue, despite the recent pop following Senate passage of the $2 trillion stimulus package. You will need to be patient and give your strategy time to work out.

Being forward-looking, the market could begin to recover even as the health-care situation is worsening. Don’t be spooked by the current volatility, but use it to wade back into the market.

Now read: Algorithms sped up selling, leading to the fastest bear market in stock market history

Vasant Dhar is a professor at New York University’s Stern School of Business and the director of the Ph.D. program at the Center for Data Science. He is the founder of SCT Capital Management, a machine-learning-based systematic hedge fund in New York City.

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