Kass: The Quant Bubble

This blog post originally appeared on RealMoney Silver on Nov. 17 at 8:04 a.m. EST.

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

-- Chuck Prince, former chairman and CEO of Citigroup (told to the Financial Times on July 10, 2007).
These words resonate to me in the current investment setting as many investors and traders are assuming the most benign of economic outcomes and have begun to dance and party like it's 1999. The media's talking heads are doing their best to fuel the celebration, just as they were at DJIA 14,000 before the market crashed last year. It is also the same group of cheerleaders that was mired in depression eight short months ago.

Some, like myself, have been cautionary (and wrong) over the past few months, expressing concerns over emerging short- and intermediate-term headwinds that threaten a self-sustaining economic cycle, including the effect of the withdrawal of monetary and fiscal stimulus. Countering those concerns has been one overriding factor -- namely, the Fed's zero rate policy and curse on cash, which has already produced its desired effect of causing investors to "look over the valley" and to buy longer-dated assets (equities, bonds, commodities).

Nevertheless, there are already some more tentative economic signs emerging in housing and in confidence, and it remains my view that the real economy will disappoint in 2010. (This more downbeat assessment seemed also to have been contained in Bernanke's message yesterday.) If I am correct, equities are in the process of disconnecting from fundamentals as they soar ever higher in the face of a self-perpetuating cycle, fueled by performance-anxiety, the unwillingness to be left behind and the growing consensus view of 3%-plus GDP growth and $80 a share in S&P 500 earnings in 2010.

As I have written previously, market participants often rationalize the irrational. If I am correct in my negative economic view, the Fed's strategy, which was aimed at inflating the prices of three assets (homes, stocks and bonds), is producing, along with higher stock prices, a widening schism between the market's perception of value and that of economic reality.

A bubble has already likely formed in the fixed-income market, gold and in non-dollar assets, and many appear to be anticipating that stocks will continue to benefit from the loose Fed. The lesson learned from the last few years, however, is that a bubble in one class can impact valuations of other asset classes, even if those classes have not gained bubble status. For example, in 2007-2008, a bubble in credit and in home prices hurt stock prices, even though equities weren't bubbly or wildly priced. Similarly, today, a bubble forming in bonds, gold and in non-dollar assets could affect stock prices adversely.

I remain a skeptic that Fed policy will be as effective as the bulls expect as I continue to believe that asset price inflation will not turn around the jobs market or induce consumers to spend nor will it produce an improvement in personal consumption expenditures; consumers are already spent-up, still remain overlevered and lack confidence about their future in the face of numerous nontraditional headwinds.

For now, though, let's throw away the fundamentals, the Fed, talk of bubbles and opinions on the economic trajectory as there might be an outside influence that is playing an increasingly more influential role and could help to explain some of the persistency of the market's advance since the summer.

A portion of the sharp rise in several asset classes over the past few months could be the dominance of quant funds that worship at the altar of price momentum (and the self-fulfilling prophecy of the fund flows that follow the price momentum induced by the quants!).

Over the course of the past few weeks, I have investigated the increased role of momentum-based and high-frequency-trading quant funds. Though hard to "quantify," I believe that the disproportionate role of these funds, which use algorithmic formulas in their directional trading strategy, is shockingly influential in the current momentum-based climate and is serving as an "invisible hand."

By some estimates, this price-momentum-based quant trading now has doubled in significance since early in the year, to more than two-thirds of the average day's trading. Trades initiated by these funds are insensitive to an underemployment rate approaching 18%, signs of an unsteady recovery in housing, the prospects for higher marginal tax rates and how we are going to finance our budget deficit, which hurdles ever higher. Really!?!

The trade of shorting the U.S. dollar, buying long-dated assets like bonds and stocks, and barreling into commodities (read: gold) and other non-dollar assets is impervious to fundamentals and is likely contributing (in part) to bubble-like conditions in several asset classes. And stocks have benefited from this wave, but it is making many look smarter than they are and making many look stupider than they are!

If you don't believe me about the growing quant fund influence, speak to any prominent institutional trader or salesman: They will tell you that their business with plain vanilla institutions is weak and that the quant funds are the ever growing whales of trading.

The pattern is all-too familiar as a new marginal buyer of an asset class dominates the market until they don't.

Here is an anecdote that underscores the changing landscape and is reminiscent of other sectors hiring at tops. (To refresh your memory, this occurred several years ago in private equity and was followed by a sharp cyclical decline in private-equity deals.) At any rate, a subscriber wrote me a telling note recently about his son's friend who attends Wharton and is "a genius in math and game theory." He was just hired by a high-frequency trading firm after being interviewed by 15 similarly talented employees at the firm. He is 20 years old and has been offered approximately $100,000 a year, with a bonus that can add up to an additional $100,000 a quarter! That's far better than even the estimable Goldman Sachs ( GS) pays!

Keep dancing if you will, but I continue to sit out the melt-up in stocks and the bubble in other asset classes. When investors/traders are arguably overinfluenced by prices (not fundamentals) that dominate the markets, and are all on a similar side, it has the potential to lead to a treacherous and slippery slope, as it did in 2007-08.

Remember, it is some of the same momentum-based quant funds that sold in March 2009 that have been buying over the past few months.

I have seen many bubbles in my 30-plus years in the investment business. There is a giant bubble in quant funds, and their outsized influence in buying stocks, bonds and commodities might soon be approaching the height its of popularity.

As was the case when Citigroup's ( C) Chuck Prince was dancing in 2007, we never know when and how these trends extinguish themselves. We do know, however, that any serious break in momentum in some of the bubblicious asset classes (perhaps caused by economic disappointment) could precipitate indigestion within the quant fund industry that could weigh on the stock market, more so than many now believe possible.

Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is the general partner Seabreeze Partners Long/Short LP and Seabreeze Partners Long/Short Offshore LP. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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