The Hidden Cost of Volatility Drag

The past year has seen significant price movements across various asset classes, with commodities and stocks being the most affected. Electronic trading, in particular, has been a key driver of these price swings, as it allows for rapid execution of trades and provides the ability to trade on margin.

Electronic trading was just in its infancy in 2000, when only new E-mini stock index markets and overnight trading were available. Its success led to efficiencies, lower execution costs, and the creation of new trading strategies. Today, electronic trading accounts for over 90% of total exchange volume, making it a dominant force in global market activity.

One key area where electronic trading has had a significant impact is on commodities. The Chicago Mercantile Exchange (CME) set a record for electronic trading volume in 2000, with over 231 million contracts traded. This was followed by the Chicago Board of Trade (CBOT), which also saw increased electronic trading activity in 2009.

However, as we look back at the past decade, it becomes clear that electronic trading has come at a cost. The widespread adoption of OTC swaps and single stock futures has led to confusion and inefficiencies in the market. In fact, Congress is currently working on rebuilding a regulatory structure that failed to detect enormous systemic risk.

Meanwhile, investment banks have benefited from the "friendly" central bank environment created by the Fed's accommodative Fed funds rates. The Commodity Futures Modernization Act of 2000 (CFMA) was hailed as breakthrough legislation in 2000, but today it is being cited as a culprit in the credit crises that nearly sent us into another depression.

The end of 2009 will be remembered for its volatility, with stocks plummeting and currencies falling sharply. However, this period also marked a turning point for electronic trading, as it became clear just how much price movement was driven by market sentiment rather than underlying economic fundamentals.

Why Most Investors Miss This Pattern

Investors often overlook the impact of market sentiment on prices, focusing instead on fundamental analysis. However, this approach can be flawed, as it fails to account for the role that psychological and emotional factors play in determining price movements.

For example, the sudden drop in oil prices in 2008 was largely driven by fears about the global economy rather than any fundamental change in supply or demand. Similarly, the decline in commodities in 2010 was influenced by a combination of factors, including a weak US dollar and increased speculation in gold.

A 10-Year Backtest Reveals...

Historical data on price movements can provide valuable insights into market behavior. For instance, a backtest of the S&P 500 index reveals that it has consistently outperformed other asset classes over the past decade, despite being heavily traded and influenced by market sentiment.

This suggests that investors should be cautious when trying to time the market, as their attempts at shorting or timing trades can actually lead to losses. Instead, investors should focus on identifying high-quality investment opportunities with a strong underlying business model.

What the Data Actually Shows

The data on price movements in commodities and stocks over the past decade provides valuable insights into market behavior. For example, it shows that the 2009-2010 period was characterized by significant volatility, driven by a combination of factors including global economic uncertainty and increased speculation.

However, this period also marked a turning point for electronic trading, as it became clear just how much price movement was driven by market sentiment rather than underlying economic fundamentals. As a result, investors should be wary of over-trading and try to focus on long-term investment strategies that can withstand periods of market volatility.

Three Scenarios to Consider

The past decade has provided three key scenarios for investors to consider:

1. Long-term investing: Investors who have chosen to hold onto their investments through thick and thin have seen significant returns in recent years. 2. Short-term trading: Those who have attempted to time the market through short-term trades have often been left with significant losses. 3. Active management: Investors who have taken an active approach to managing their portfolios, using techniques such as hedging and sector rotation, have seen improved returns over the past decade.

Ultimately, investors should be cautious of making impulsive decisions based on market sentiment rather than fundamental analysis. By focusing on high-quality investment opportunities with a strong underlying business model, investors can build long-term wealth through careful and disciplined investing strategies.