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The
Significance of Recent Stock Market Volatility
August delivered a
modestly positive month for stocks, which have been down 7 of the last 11
months since stocks peaked in October 2007. The first week of September erased
those gains and more. Since July 1st,
the stock market has gained or lost 1%/per day 51.0% of the time compared
to 12.8% of trading days in the calmer days of 2006. Even more remarkably, stocks have moved
intra-day (high versus low) 1% or more 89.8% of trading days since July 1st,
and 2% or more 40.8% of the time.
Stocks were less volatile in 2007 and dramatically less volatile
in 2006.
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7/1-9/9
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1%
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2%
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3%
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Day to day
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2008
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51.0%
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16.3%
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0.0%
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moves
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2007
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50.0%
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14.6%
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0.0%
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2006
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12.8%
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0.0%
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0.0%
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7/1-9/9
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1%
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2%
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3%
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Intra-day
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2008
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89.8%
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40.8%
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2.3%
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moves
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2007
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72.9%
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33.3%
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8.6%
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2006
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37.5%
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2.1%
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0.0%
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Through Monday
night, the S&P 500 was down just 1% on the quarter. However, worries (real or not) about
Lehman Brothers on Tuesday knocked that stock down 44% on the day and
down over 50% in the last 5 days.
The stock market was modestly higher at 10AM, but turned negative
shortly thereafter, with a decline accelerating into the close down 3.4%
and with 7 stocks declining for every one stock that was up. This was the worst decline for the
S&P 500 since February 2007, coming one day after the best rally in a
month. How can bad news about one
company, true or not, have such an impact on the rest of the market?
Still a
bear market
Part of the
problem is that US investors are still afraid of putting money back to
work in stocks. In July, investors
pulled $26.4 billion from stocks funds, the biggest outflow since January's
redemption of $44.84 billion. YTD
through August 20th, investors withdrew a net $59.1 billion,
or 1.5% of total stock fund assets.
This unfortunate behavior of selling when stocks are low, and
buying when stocks are high, does not account for the massive increase in
volatility, however. To answer
that question, we need to consider how the stock market trading mechanism
has evolved in recent years.
The Demise
of the Specialist System
From the inception
of the New York Stock exchange over 200 years ago, the primary function
of the exchange was to provide a reservoir of capital by which
specialists would buy stocks when investors were net sellers, and sell
stocks when investors were net buyers, keeping an inventory of stock on
hand to smooth out imbalances. A
parallel system of "market makers" performed a similar function
in stocks traded "over the counter" on NASDAQ.
This system began
to break down in the 1990's as the specialist firms simply didn't have
enough capital to provide a buffer as the total market value of US stocks
moved into the trillions of dollars.
At the same time, institutional investors began to chafe at the
trading costs of funneling millions of shares through the tiny portal of
the New York Stock Exchange.
Parallel systems, called "crossing networks," developed
where large block trades could be matched outside the exchange, and the
result simply reported. Meanwhile,
since 1976, the NYSE has crossed smaller orders through SUPER-DOT, an
internal crossing network. This
system originally handled orders up to 199 shares, expanded to 2,099
shares by the mid 1980's and to the current limit of 30,099 shares in
1989. As a result, the percentage
of trades actually filled on the floor of the exchange is in the low
single digits. The trading floor
that is seen behind the CNBC anchors first thing every morning could be
closed tomorrow with no material impact on routine trading.
SEC
regulations to improve trading efficiency have unintended consequences
The US Securities
and Exchange Commission implemented a number of market reforms in recent
years to improve trading efficiency.
Quotations of stock prices went from 1/8's of a dollar to decimal
fractions of a dollar. Although
this may seem of little importance, the intent was to shrink bid/ask
spreads. 20 years ago, the
difference between buying and selling a share of exchange traded General
Electric might have been 25 cents, or 75 cents for an over the counter
stock like Microsoft. Now the
spreads are a few pennies for large cap stocks. Although trading volumes have expanded
and are huge, specialists and market makers are finding it ever more difficult
to make money on such narrow spreads.
Commissions, another source of revenue, have been squeezed down to
fractions of pennies per share. In
years past, specialists would be willing to absorb stock at a loss during
selling panics because of the spread profits from routine trading. Now the specialists just step aside and
let prices collapse. Neither the
crossing networks nor SUPER-DOT have any obligation to provide the buffer
function.
In July 2007, the
SEC removed the "down-tick" rule, which prevailed on the NYSE
since the 1930's. This rule
required an investor who wanted to sell short (borrow stock, sell it at
the prevailing price in hopes of profiting by buying the stock back later
a lower price) to wait for an "up-tick" - last trade same price
or higher than the previous trade.
This prevented unscrupulous traders from jamming down on a
stock. This rule was not applied
to the over the counter market.
Small cap companies there were particularly vulnerable to
"bear raids" where sell orders would flood the market. There is speculation that Bear Stearns
was itself a victim of a "bear raid." Traders aggressively shorted the stock
and bought puts while simultaneously spreading rumors that Bear Stearns
was insolvent. The falling stock price
was "evidence" that the broker-dealer was in trouble, leading
to more selling and eventually the demise of the company.
Short
Selling and the Rise of the ETF
In principal
"bear raiders" still can't short stock if they can't borrow it
first. However, the SEC has been
lax in following up with broker dealers that consistently fail to deliver
borrowed stock, so aggressive traders are shorting stock without going to
the bother and expense of actually borrowing shares. This creates more shorting pressure
than if the SEC was properly enforcing the rules. Lastly, traders can now short Exchange
Traded Funds (ETF's) which represent baskets of stocks rather than the
actual stock itself. ETF's are
considerably easier to short than actual stock because there's no
tangible security, just a notation on the books of the ETF sponsor. Although the ETF is supposed to track
the prices of the underlying securities, enough selling pressure on the
ETF can translate into selling pressure on those securities.
Hedge Funds
and Quant Traders
The concept of
investing equal amounts of capital in long and short securities positions
(the "hedge") originated with a journalist turned money manager
Alfred Winslow Jones in 1949.
However, the modern hedge fund industry really didn't take off
until the 1980's as early fund managers such as George Soros, Michael
Steinhardt and Julian Robertson began earning headline worthy
returns. The "hedge"
part became as misnomer, as managers began borrowing funds to enhance
returns. In recent years, many
"wannabe" managers have left employment at the proprietary
trading desks of the major banks and started their own firms, which
should be called "aggressively leveraged one-way bet"
funds. Many strategies boil down
to, "We'll make great returns for you for 3-4 years and charge
outrageous fees. In the final
year, we'll lose all your money, but we won't give you back our
fees."
We've seen a
number of those funds with aggressive long positions in energy
commodities as well as related companies go out of business in recent
weeks as energy and energy stocks have fallen 30% from recent highs. Last week, a fund that had aggressively
shorted the US dollar liquidated its positions in the face of a 12% rise
in the dollar. Every time a hedge
fund liquidates, all its collateral gets dumped on the market, which is
why stocks fell violently the first week of September in the face of no
news other than funds liquidating.
One type of hedge
fund is a quantitative trading or "quant" fund. Rather than investigate the
fundamentals of companies in making investment decisions, quant fund
primarily look for trading anomalies in the stock trading patterns. A plain vanilla example is that Dell
trades in a historical pattern relative to Hewlett Packard. If the pattern deviates, then the quant
fund shorts one stock and goes long the other, closing out the trades
perhaps seconds or minutes later as the anomaly disappears. A number of quant strategies boil down
to figuring out which companies other investors are buying, and going
long, or figuring out which companies other investors are selling, and
going short. This rapid fire
trading is enabled by the previously described mechanisms to increase
trading efficiency - reduced spreads, miniscule commissions, executing
trades at the crossing networks.
However, the net effect is to exaggerate stock price moves in
either direction.
To
summarize
· Buy and hold investors are out of the market
· The specialist/market maker system no longer buffers
supply and demand for stocks
· Increased trading efficiency has reduced the cost of aggressive
trading
· Shorting is too easy
· Hedge funds dump positions not when they want to, but
because they have to
· Quantitative trading overwhelms fundamental investing
The analogy
of the life boat
The cruise ship
sank, but the passengers (investors) and officers (money managers) are in
the life boats (the stock market.)
The officers have organized the passengers, who are now rowing
toward land and bailing when necessary.
Occasionally storms (market events) blow up and some of the
passengers panic and fall out of the boat. As long as the rest stay calm, all will
make it to land (retirement, pension plan funded etc.)
On some boats,
however, the officers have started leaping from side to side, somehow
convincing the passengers that this will propel the boats to land faster
(enhanced returns!) Now all the
passengers are leaping from side to side; with each roll, more fall
out. Worst of all, those life
boats are in serious danger of capsizing (forced liquidations.) Which lifeboat would you rather be in?
Strategy
We felt that the
July 15th sell-off marked the low for this particular bear
market. Our analysis was tested
earlier this week by the demise of Fannie Mae and Freddie Mac, but at
least as of this morning, the mid-summer lows are holding. Stocks looked
equally grim June 2002 through March 2003 at the tail end of the last
bear market. Once investors
finally got their bearings, US stocks gained 34.6% over the following
year, 41.7% over two years, and 58.2% over three years. There is no guarantee that we'll see
similar returns over the next three years, but historically those
investors willing to hold stock positions through the end of the bear
market obtained the largest returns.
Our job at this stage of the game is to keep clients invested to
reap the rewards of patience.
Yours sincerely,
David Edwards
President
The Heron Capital Management
client letter is published immediately following month end and when
market conditions require comment. The views expressed in this letter
represent HCMI opinion and strategy as of the date published and can
change at any time upon receipt of new information. Data quoted in this
letter are from sources deemed reliable, but no guarantee of such data is
implied.
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