Capital Market Comment
March 3, 2020
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
Is the coronavirus that pervasive and destructive as to generate a market decline in 5 days that has caused a meaningful and painful correction (10% or more) in the market averages and many individual stocks? Most certainly the coronavirus has disrupted business activity in numerous countries, some more than others – China, Japan, South Korea, just to name a few. Travel restrictions, supply chain delays, and quarantines will lead to weakness in world economic activity in Q1. A number of companies like Microsoft, Apple and NXP Semiconductor have already given indications of the effect of the virus outbreak on their businesses. But recently, China has begun to send people back to work. Although the disruptions in other countries as well as in the United States has yet to play out, the return to normalcy is likely to take time and be spotty, but should be quite evident in the spring.
What is particularly interesting, confusing, and lacking adequate explanation is the speed of the decline and what appears to be the failure of the normal discounting process that goes on in the equity market.
The potential coronavirus effects on business activity had been discussed for weeks before the selloff and yet the market made a new high during that period. Then why suddenly a change, so much, so fast? One has to look beyond the virus and even the political landscape to understand the near-term behavior. The market construct that has been developing for years with the emergence of program trading, algorithms, hedge funds of all varieties, financial futures, options on futures, momentum funds (strategies), Robo investing, smart Beta, managed futures, etc. is a major contribution to the depth and decline of the market. The flash crash on May 6, 2010 was triggered by the use of derivatives like E-mini S&P 500 stock index futures contracts and options on futures. The August 24, 2015 crash caused massive mispricing of ETFs to their underlying stocks. Spoofing algorithms, layering, and front running were subsequently blamed. Even in the 1987 crash, a Wall Street creation called portfolio insurance using derivatives failed and added to market dislocations. After 9/11 (September 11, 2001) the stock market was closed for 4 days and fear was pervasive. The options market ceased to function and was never re-dated, so massive losses were incurred when the markets opened. Once trading resumed, the market declined 12%. 9/11 was an exogenous event as is the coronavirus that sent shock waves through the system. The market subsequently recovered.
As it relates to our current environment, Marko Kolanovic, a JP Morgan strategist, suggested that approximately $150 billion worth of stock selling from computer-driven traders and option hedgers drove the S&P 500’s worst two-day slump since 2015.
Many of the derivatives strategies that have been created purport to provide hedges against volatility and downside protection in a market decline. In reality they often fail, in part, because in such volatile periods the markets become dysfunctional and pricing becomes irrational (wide gaps between the bid and ask, distortions between the price of the underlying securities and the ETF/commodities fund/financial futures, and high premiums in the options market). The use of leverage further exacerbates the price movements.
About $18 billion left U.S. mutual funds and ETF’s during the week ending Wednesday, February 26, 2020 according to Bank of America. Thursday and Friday marked even higher trading volume. We should expect the continued volatility and some mispricing. According to Alight Solutions, trading volume in large employer retirement accounts was 11 times higher than normal on Thursday. A lot of entities/people were heading for the exit at the same time and it got very crowded. Passive investors, who are supposed to be long-term and buy index funds, also joined the frenzy and fled the market.
Trading volume in the S&P 500 ETF rose 300% on Thursday according to Jonathan Krinsky, Chief Market Technician at Bay Crest Partners. Over the next several weeks, it is very likely that the damage to the derivative products and the investors in those products will become apparent. Once again, many derivative products will prove to be “investments of mass destruction.” When fear takes over it gets very ugly and irrational.
With massive volume and a swift race to the door, you ask yourself who are the buyers? Are they fools? Why would they buy in such a volatile and uncertain environment? Maybe they view it as an opportunity.
If you have a question or need further information, please contact:
Don Keeney, CFA, CFP, Principal & Portfolio Manager in Nashville at 615-866-0882, or email@example.com
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or firstname.lastname@example.org
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