As We Learned In 1987, the Unexpected Often Moves Markets
Are late-day ETF buy/rebalancing programs and the proliferation of price momentum (quant) strategies the 2017 equivalent of 1987's portfolio insurance?
And does it end badly?
Yes, it probably does!
"I have learned through four decades of experience that once most market participants are conditioned to one way of action, the other way quickly may surprise them as rising markets brings rising expectations, and vice versa.
Those expectations can be argued to be at their highest level at any time in this bull market that started in the first week of March 2009.
Optimism in and of itself is not dangerous, but it is tautological that risk and disappointment expand as optimism multiplies.
That optimism is readily apparent as retail investors massively embrace passive investing in their accumulation of exchange-traded funds -- a shift in behavior showing a willingness to commit to the long term in our markets.
This could explain the late-in-the-day market ramps. To digress, I would note that, year to date, 37% of exchange value has occurred in the last 30 minutes of trading. This can be explained in large part by the enormous popularity of ETFs that are forced to rebalance during the late minutes of the trading day."
--Kass Diary, "Everything's Awesome ... But For How Long?"
In the two years leading up to 1987's Black Monday, after several years of rapid economic expansion following the recession of the early 1980s, the rate of growth in the U.S. economy began to slow. Notably, the early 1986 collapse of OPEC led to a halving in the price of crude oil by mid-1986. Nevertheless, the stock market indices enjoyed rapid growth amid an expansion in valuations, fueling a 45% year-over-year gain in the Dow Jones Industrial Averages by late summer 1987.
There were several factors that lead to Black Monday on Oct. 19, 1987, when the DJIA plunged 22.5%. They included an overvalued market, illiquidity, market psychology and, perhaps most importantly, the dominant role and innovations with index futures, program trading and portfolio insurance:
"The internal reasons included innovations with index futures and portfolio insurance. I've seen accounts that maybe roughly half the trading on that day was a small number of institutions with portfolio insurance. Big guys were dumping their stock. Also, the futures market in Chicago was even lower than the stock market, and people tried to arbitrage that. The proper strategy was to buy futures in Chicago and sell in the New York cash market. It made it hard - the portfolio insurance people were also trying to sell their stock at the same time."
--Richard Sylla, professor of economics, New York University, from "The Wall Street Journal"
In response to Black Monday, regulators overhauled trade-clearing protocols to bring uniformity to trading; they included trading curbs and circuit breakers in an attempt to halt large declines in the prices of the market indices.
If it was the latter's influence -- a crash caused by computerized selling required by portfolio insurance hedges -- that may hold some relevance today.
The Proliferation of ETFs and Quant Trading
"ETFs are a 'digital-age technology' governed by 'Depression-era legislation.'"
- Morningstar, Dec. 6, 2015
Just as portfolio insurance was in 1987, ETFs and price momentum-based quant strategies are the tail that wags the market's dog in 2017.
As retail investors have withdrawn from the process of buying of domestic equity funds and have moved into passive exchange-traded funds and with the dominance of quant trading, an estimated 75% of average daily trading volume is derived from ETFs and quants participation.
Thus far, with the possible exception of the May 6, 2010, "Flash Crash," the markets have been unimpaired by the proliferation of ETFs and quant strategies such as volatility trending and risk parity.
Indeed, the upward trend in markets is abetted by a regular pattern of late-day buying as ETFs rebalance with ever more buying, and price momentum quant strategies follow suit. (Note: As mentioned previously, nearly 40% of daily volume is taking place in the last 30 minutes of trading every day. This regular pattern of buying has caused whatever short sellers remain to tear their hair out in frustration with this positive bias!
A Trend Change in Price Is Almost Inevitable
That said, regulators seem to be using bicycles to try and catch Ferraris and it might be only a matter of time before there is another market incident, as occurred in October 1987, when the primary direction of stock prices starts moving from the upper left to the lower right (thanks for that phrase, Dennis Gartman!).
At that point in time the computers no longer will be buying; they will be selling.
It is at that point in time when the movie will be seen in reverse and end-of-day selling will replace the persistent end-of-day buying that has characterized the last few years of trading.
Remember, as we learned 30 years ago, the unexpected often moves markets, for as I wrote above:
"I have learned through four decades of experience that once most market participants are conditioned to one way of action, the other way quickly may surprise them as rising markets brings rising expectations, and vice versa."
