After 28 years making my living in the capital markets, it takes something really unusual to shock me. Let me say that it is not the sharp price drops, as unpleasant as they have been, that have been the big surprise in this market correction. It is the huge point swings and volatility. Never before have we seen such violent intra-day movements in the major indexes. Where once we thought a change in the Dow Jones Industrial Average of 200 points was significant, we are now seeing moves of 200 to 400 points in a few minutes. What is going on here?
In our view, there are three major factors which have combined (I hesitate to invoke the much over-used perfect storm metaphor) to create this volatility. It is fair to say that nobody intended the markets to end up acting this way. It is a more a result of a number of trends which all became more significant over time.
The growth of Exchange Traded Funds (ETFs)
An ETF is like a mutual fund. It is a basket that contains a number of securities selected to meet an investor’s goals. The most popular ETFs are designed to mimic the major stock indexes like the S&P 500 or the Dow Jones Industrial Average. If you buy, for example, the iShares S&P 500 ETF, managed and marketed by Blackrock, you essentially own a piece of all the most important stocks on the American stock exchanges. The manager of the ETF ensures that the product precisely matches the performance of the index by purchasing all of the stocks in the index in precise proportion to their weight in the index. For example, if Apple makes up 10% of the value of the S&P 500, the ETF manager must ensure that at all times, the ETF has exactly the number of Apple shares that make up 10% of the value of the ETF. So, what happens if a lot of investors suddenly want to sell their ETF units? Obviously, the manager has to sell the shares held by the ETF to get cash, and they must be sold, just as they were purchased, in exact proportion to their weight in the index. Thus, for the manager, there is no ability to discriminate among stocks based on measures of value, future prospects or any other criteria. It is a completely mechanical process. This is a major reason why we have seen great companies like Amazon and Google, largely unaffected by the current health crisis, sell off at the same time as those companies profoundly affected. To quote the Godfather “it’s not personal; it’s just business”.
The growth of computer-driven trading
Over the last ten years there has been a rapid growth in two forms of computer-driven trading. The first is “High Frequency Trading” or HFT. Here, computers attempt to exploit small and usually momentary pricing differences in securities by placing trades very rapidly, usually in milliseconds. It is estimated that HFT accounts for up to half the trading volume for some stocks. Generally, this process is benign, as the changes in price are usually very small. A more important and perhaps more dangerous form of computer trading is “Algorithmic Trading”. Major institutions such as hedge funds, pension funds and endowments employ managers who have designed complex computerized strategies. Computers are programmed to automatically execute these strategies making rapid buy and sell decisions without human supervision. When markets are behaving normally, this does not cause problems. However, when markets are in turmoil, as they have been in the past month, the algorithms may not work as intended by the managers. They may react, for example, to the liquidation of stocks by exchange traded funds by piling on and causing an ever-growing cascade of selling. As the algorithms trigger selling, they cause distress among retail investors who then sell ETFs, which cause the algorithms to sell even more. We believe that this feedback loop is responsible for much of the volatility we have been witnessing.
Liquidation of margin accounts
All brokerage firms allow their customers to borrow money against the value of the securities in their account, in order to buy more securities. This buying “on margin” works well when markets are rising, as investors (or speculators) have more buying power and can make larger gains. However, when markets are falling, the value of the securities in the investor’s account may become too low to secure the value of the amount borrowed. In this case, the brokerage firm will force the investor to liquidate securities to pay back all or part of the loan. If this forced liquidation becomes widespread, it can lead to selling in the market that is not related to prices or the desire of the (now former) owners of the securities. Many believe that the great stock market crash of 1929 was caused, at least in part, by forced liquidation of margin accounts. We know that in the past year, with strong gains in the markets and low interest rates, the amount of margin debt in retail accounts had grown to a record level. Much of this debt was used to buy speculative securities such as Tesla or cannabis stocks. As these stocks fell rapidly (Tesla is down more than 55% this month and marijuana producer Tilray has fallen from $300 to under $3), forced liquidation occurred. Indebted borrowers were forced to sell not only the speculative issues, which fell so sharply in value, but also their higher quality more liquid stocks such as banks and telephone companies. This added to the downward pressure on stock prices for all securities.
The combination of ETF liquidation, algorithmic trading and liquidation of margin loans is not the cause of the recent market fall, but these factors have combined to accelerate it and create heretofore unimagined volatility. Fortunately, we think we will soon see, if not a reversal of this trend, at least an abatement in its influence. In the first place, much of the margin debt must surely have been repaid by now. Secondly, we believe that most of the selling that forced liquidation by ETF managers has already taken place. A reduction in such selling will remove much of the pressure from higher quality stocks. Finally, we hope that managers and programmers have recognized that their algorithms need adjustment and are making changes.
As our clients know, we believe that price and value are two different things. The current market drawdown has made this clearer than ever. There are many stocks which we believe have prices that are far below their value. We will write further about this soon. In the meantime, the best remedy for the current volatility is to ignore it to the extent possible. Much of it is noise that conveys very little, if any, real information on the value of stocks.