Flash Crash: Rage Against The Machine by Worth Wray of Evergreen Gavekal Capital
“The world clings to its old mental picture of the stock market because it’s comforting; because it’s so hard to draw a picture of what has replaced it; and because the few people able to draw it for you have no interest in doing so.” – Michael Lewis, author of the bestseller Flash Boys
Summary Of EVA’s Key Points
The second widespread US equity “Flash Crash” on August 24, 2015 was a wakeup call for investors.
- In addition to the S&P 500’s 5% fall as the market opened, blue chip stocks and large “exchange traded funds” (ETFs) suffered enormous 20%+ drops before recovering almost all of their losses in a matter of minutes.
- As Jeff Dicks explained in our September EVA Chartbook (“Flash Crash 2.0”), this kind of price action is a sign that financial markets have changed in a fundamental way.
The decline of “market making” activity has reduced daily trading volume on major stock exchanges and increased the risk of liquidity shortages in times of panic.
- Market makers play a critical role in keeping major financial markets liquid and, at times, have been the only parties standing between orderly sell-offs and disorderly crashes.
- By consistently taking the other side of trades – i.e. selling when the herd bought and buying when the herd sold – they once accounted for a tremendous share of daily trading volume on the New York Stock Exchange, the NASDAQ, and other exchanges.
- Because these firms either went out of business during the 2008 financial crisis or have been forced to operate at much lower levels of leverage to comply with new regulations, daily trading volume on the NYSE has been cut in half.
Dramatic changes in the mix of market participants has fundamentally changed the way US equity markets behave.
- As “real money” – including households, institutions, and market makers – has fallen in overall trading since the global financial crisis, “high-frequency traders” (HFTs) and ETFs have grown to account for nearly 70% of daily trading.
- Because of that radical change in market participants, human emotions like fear and greed do not explain everything we are seeing in the markets today.
- Now we also have to think about computer programs, passive investment structures, and rules-based investment strategies that can collectively increase market fragility and compound selling pressure when markets turn.
- The result is a market where liquidity can dry up without notice and prices can overshoot even further than in the past in both directions.
While high-frequency traders account for the lion’s share of trading volume today, they are not market makers and have very little skin in the game.
- HFTs are investment firms that have replaced human beings with sophisticated computer programs designed to constantly exploit tiny inefficiencies in liquid markets.
- By colluding with the exchanges and broker/dealers, HFTs have gained a small speed advantage over everyone else in the stock market, which allows them to receive, process, and act on information faster than you can even imagine.
- As we saw in the May 2010 “Flash Crash,” HFTs can disappear from the market when trading becomes disorderly, contributing to a collapse in perceived liquidity and a steep drop in prices.
In addition to contributing to the fall in trading volume and a rise in herding behavior, the ongoing migration from active investing to passive vehicles like exchange traded funds leaves some investors particularly vulnerable.
- ETFs are baskets of securities that trade on the open market and represent various markets, industries, geographies, or investment themes.
- As of year-end 2014, ETFs accounted for $2.6 trillion in total assets under management.
- Because these funds trade on the open market, they are just as vulnerable – perhaps more vulnerable – to sharp dislocations given market makers’ limited risk budgets, HFTs’ tendency to withdraw from disorderly markets, and the potential for ETFs to continue trading when their underlying constituents are not.
So, you ask, what does this mean for my portfolio?
- The Evergreen GaveKal investment committee is increasingly concerned that a major correction is coming and believes that structural changes in the composition of market participants raise the odds of a more severe crash when that time comes.
- Furthermore, temporary dislocations in intraday trading can hurt emotional or ill-prepared investors and/or present enormous opportunities for those who have a plan in advance.
These insights argue for rethinking the investment process in five ways:
- Know your risk tolerance and expect more severe volatility.
- Don’t allow yourself to get forced out of positions when selling frenzies occur.
- Have a plan to capitalize on wild price swings, knowing that the regulators may or may not cancel those trades.
- Watch for macro or policy breaking points that HFTs cannot anticipate.
- Slow down and take a longer term view. There is opportunity in chaos!
Rage Against The Machine
Monday, August 24 was a huge wake up call for US equity investors as the S&P 500 dropped nearly 5% at the open in what my colleague, Jeff Dicks, is calling the “Flash Crash 2.0.”
In one of those moments where you immediately know if you’re taking too much risk in your portfolio (you start feeling afraid of potential losses) or if you’ve adequately prepared for a correction (you start feeling excited for potential buying opportunities), it felt like the markets were coming unglued with blue chip stocks like CVS, General Electric, and JPMorgan down nearly 20% and then snapping back a few minutes later. Trouble is, not all investors snapped back so easily. Unlike the “Flash Crash 1.0” in May 2010, the exchanges have allowed all trades made that day to stick.
The scary/exciting thing is that these types of dislocations are now a natural element of the market landscape considering how the structure of market participants has changed in recent years. Human emotions like fear and greed are no longer the only forces behind market prices. In fact, human beings account for less than half of the trades that occur on the New York Stock Exchange. Now we have to think about computer programs, complex algorithms, passive investment structures, and rules-based investment strategies that collectively compound the selling pressure when markets turn.
See full PDF below.