If a correction comes, blame the robots

Published Mon, Oct 13 2014 1:44 PM EDT

"The only thing we have to fear is fear itself."
– President Franklin D. Roosevelt, inaugural address, 1933.

So? Should investorsbe fearful? Is this the big one? Remember – it IS October so now we must ask -Will the October curse live on? Yes, the markets took a beating last week and this week it doesn't look much better.

Colin Anderson | Getty Images

On Tuesday, the Dow sold off 1.6 percent while the and Nasdaq

As of Friday at 4 pm, the Dow is off 4.2 percent from its high, leaving it flat on the year. The is off 5.2 percent from its high leaving it up 4 percent for the year. The Nasdaq is off 7 percent from its high and is still up 3.2 percent on the year. The Russell (small caps) is down 13 percent from its high is the only formal index that is in real correction territory and I would argue that says little about the broader concerns.

Take a look and ask at the macro data — What has changed that we did not already know?

Strong dollar?The dollar has been getting stronger for 3 months – so this is not new.

Weaker Europe? Europehas been weak for years now – so not new.

Federal Reserve withdrawal? — Really? This is not new.

Rising Interest rates? Not happening any time soon — not new.

Falling oil and food commodity prices? A windfall for th eglobal consumer.

Falling industrial metal prices? World demand is drying up? Hardly.

Ebola? Not so much – Makes a compelling story – but means nothing for the long-term investor.

China – hard landing? They have been saying that now for months – not new. The Chinese market is up 13 percent year-to-date.

Third-quarter earnings? They're expected to be strong and stable. Companies have adjusted and analysts have revised forecasts – lower – so what's the issue? We already and they already know that a stronger dollar and a weaker Europe will have an impact and stocks have already been re-priced as a result.

Germany? Weakening data of late – this IS new and the reason for the broader concerns of late – but it may not be enough to take down the U.S. market.

So, will the fear become a self-fulfilling prophecy? A prediction that causes itself to become true by the very terms of the prophecy. We might see a herd-like mentality take over as the talk of the correction heats up and algorithms run wild – unable to discern the veracity of the news, reacting only on risk parameters that end up feeding on themselves causing selling to beget more selling causing the prophecy to become true.

Recall – for those of you who can – Oct. 19, 1987, a dark day in history. Portfolio insurance, a risk-management product gone bad, was an early iteration of the current algorithmic risk-management tools that react only to data and technicals – unable to assess the reality able only to respond to data. Void of any interpretation at all.

The global crash came that day because we allowed computers to make investment decisions without questioning. The logic was: If the computer says I must sell X percent of my portfolio to protect it, then I will do that. The problem was that all of these asset managers bought the same protection and then they all got the same "sell" signal, which, then by default, caused a circular reaction. Selling created more pressure to sell and the cycle kicked in again.

This may be the only reason that the correction will come – because we allow the investing process and the execution process to be run by robots. Robots that have no "skin in the game." That being said, it is exactly this process that will create an opportunity.

Watch as third-quarter earnings kicks off this week - JPM, WFC, C, Google, GE (to name just a few) are expected to make it exciting. FactSet suggests the usual – that at least 70 percent of reported earnings will beat the estimates and overall analysts are expecting that we will see some 4.5 percent earnings growth. Good earnings will be sure to bring plenty of opportunities over the next couple of weeks – opportunities that will be created by panicky investors who are running on autopilot.

Under more normal circumstances I would not believe that this is the beginning of the correction –I do, though, believe that technically the market has suffered some damage and needs to re-group. Churning and volatility will result and a break of the 200-day moving average on the S&P that will cause the algo's to kick into high gear. Buyers will retreat and move lower and let the sellers come to them – the more pressure created by the algo's, the lower the buyers will move essentially allowing the prophecy to become reality.

All that being said, the fundamentals are not as bad as recent market action makes it seem. We have been living with a weaker Europe for years now, we have been living with the eventual end to quantitative easing and the possibility of rising rates for 8 months now, we have been living with the geopolitical concerns forever. So, I ask again — what has changed? In the end, we have given up the ability to control the markets when we allowed the technology to operate on auto pilot. My advice: Take back the night and use the technology for efficiency and use our brains for interpretation.

Commentary by Kenny Polcari, director of NYSE floor operations at O'Neil Securities. He is also a CNBC contributor, often appearing on "Power Lunch." Follow Kenny on Twitter @kennypolcari and visit him at kennypolcari.com.

Disclosure: The market commentary is the opinion of the author and is based on decades of industry and market experience; however no guarantee is made or implied with respect to these opinions. This commentary is not nor is it intended to be relied upon as authoritative or taken in substitution for the exercise of judgment. The comments noted herein should not be construed as an offer to sell or the solicitation of an offer to buy or sell any financial product, or an official statement or endorsement of O'Neil Securities or its affiliates.

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