Introduction
Price insensitive sellers are forced to sell at whatever prices they can get. Emotionally they feel that they have no alternative than to convert their assets into immediate cash to meet pressing needs. On the other side of the trade are buyers who have innumerable choices both in terms of what assets to buy and what prices they are willing to accommodate the driven sellers. This is one of the two big lessons from last week's market turmoil. The other lesson are the answers to “what did we learn about ourselves as investors?” I plan to explore that subject in next week’s post.
Price insensitive sellers are forced to sell at whatever prices they can get. Emotionally they feel that they have no alternative than to convert their assets into immediate cash to meet pressing needs. On the other side of the trade are buyers who have innumerable choices both in terms of what assets to buy and what prices they are willing to accommodate the driven sellers. This is one of the two big lessons from last week's market turmoil. The other lesson are the answers to “what did we learn about ourselves as investors?” I plan to explore that subject in next week’s post.
Co-Venture Risk
One of the big failures in teaching investments is only using quantitative analysis of price, cash flow, earnings and book value. The approach
Fundamental and
Emotional Perceptions
In
attempting this very difficult analysis of guessing the cards of the players
opposite me at the gaming table, I find it useful to divide the effort into two
parts. The first and easier of the two is what would cause the co-venturer to
change his or her perception of our shared investment; e.g., a view on the
appropriateness of management's actions, or a similar point. The second and
more difficult effort is to attempt to fathom out changes in the financial or
emotional needs of the co-owner who becomes highly motivated by internal pressures
to sell for reasons other than price. In other words, what would cause my co-venturer
to become an immediate price insensitive seller?
Two Price Insensitive but Understandable Sellers
Another technique to understand what happened last week is to view the world (as I do) through the lens of mutual fund performance. For the week ending Thursday August 27th , there were only two types of fixed income mutual funds declining 1% or more, US General Treasury funds -1.3% and Emerging Market Local Currency Debt funds, also declining 1.3%.
Two Price Insensitive but Understandable Sellers
As
a manager of institutional and high net worth accounts, I am well aware of
planned and unplanned needs for money. On any given day there are other
investors that are meeting similar needs, but for the most part these
transactions are relatively small in scope and do not have price moving
impacts. When a very large or a group of large players come to the table for
immediate action regardless of price, they temporarily become the dominant
players in the market and therefore the settlers of price reactions.
To put last week's price movement into some perspective, instead of looking at market indices, I looked at the prices of some very high quality stocks and their prices to gauge the intensity of the sell-off. For illustrative purposes I will use a personal holding in JPMorgan Chase. On Monday the 24th of August it opened down from the prior Friday's close at $59.29 and quickly sold-off to $50.07 and to finish the day at $60.25 and the week at $64.13. The drop early on Monday was part of the rattling 1000 point fall in the readings of the Dow Jones Industrial Average.
To put last week's price movement into some perspective, instead of looking at market indices, I looked at the prices of some very high quality stocks and their prices to gauge the intensity of the sell-off. For illustrative purposes I will use a personal holding in JPMorgan Chase. On Monday the 24th of August it opened down from the prior Friday's close at $59.29 and quickly sold-off to $50.07 and to finish the day at $60.25 and the week at $64.13. The drop early on Monday was part of the rattling 1000 point fall in the readings of the Dow Jones Industrial Average.
While I am not a full time bank
analyst, I saw nothing on Monday that would have dictated that kind of price
action on relatively high volume. As a matter of fact I am beginning to think
that banks’ exposure from loans to highly leveraged domestic oil and gas
producers could be a problem. Accepting the questionable assumption that these loans will be defaulted, the issuer will go bankrupt. Thus the lenders
will be forced to take over the borrowers temporarily. Due to substantial operating
cost reductions, the banks are likely to find that the underlying equity to be
sold to surviving energy companies will more than pay off the prime loans owned
by most banks. Therefore, to my mind, the risk to most major banks' balance
sheets is reduced. This is a classic example of an insistent seller meeting an
immediate need for cash regardless of price. The seller could have been
liquidating a margin call. (Under prior market regulations the stock specialist
on the floor is responsible for maintaining orderly markets and would have to
explain to the Exchange and possibly the SEC why it should not receive a large
fine and lose the right to make that market on the floor.)
Another technique to understand what happened last week is to view the world (as I do) through the lens of mutual fund performance. For the week ending Thursday August 27th , there were only two types of fixed income mutual funds declining 1% or more, US General Treasury funds -1.3% and Emerging Market Local Currency Debt funds, also declining 1.3%.
The Chinese Government, the Big Seller
I have maintained for a long time that whether one invests directly into China or not the actions of what happens within China will be the single largest impact on global markets. This last week underlined the importance of China to our markets.
Excess cash has been flowing out of China from wealthy individuals pursuing various activities. At the same time, exports from China are growing more slowly. The combination of the slowing global economy and rising labor costs within the country, means that China is earning less than it did to fund infrastructure, food, and health requirements to sustain the ruling party in power. In order to meet these pressing needs the government has been selling down its huge hoard of US Treasuries and at the same time slightly devalued its currency. One needs to remember that short-term US Treasuries are an important collateral for many market sensitive loans. Any pressure on Treasury prices can and probably did drive some margin calls.
What most financial analysts focused on in terms of China were its financial assets and liabilities. They should have looked deeper into the generator of these elements which is the nature of its exports and imports. China’s favorable trade balance was shrinking at the very same time that the US swung to its own favorable trade balance in the second quarter, after two quarters of being unfavorable. Thus for the aware, the actions of the Chinese leadership should not have been a total surprise.
The Second Price Insensitive Seller
While the primary depressant last week was the actions that emanated from Beijing, the second insistent sellers were traders that had or were about to receive margin calls on their Exchange Traded Funds (ETFs). When looking for hedging devices hedge funds and others have determined it was cheaper to use ETFs than to use futures. In the lackluster, thin market that had many stocks declining and only a relatively few momentum stocks rising there was an increasing need to hedge. In a period of low returns which we have been going through for more than a year, leveraging becomes attractive with its low manipulated interest rates. On Monday due to changes in market rules and some lack of demand in late August, approximately 1300 stocks on the floor of the New York Stock Exchange either could not open or had to be temporarily suspended. Approximately 500 of these were ETFs. One extreme example is an equally weighted S&P 500 index fund which in the first hour of trading was only open three minutes.
To
take a somewhat longer term view of the impact of ETFs on the general market
remember the performance of thee three general market indexes: S&P 500
-2.36%, DJIA -1.98% and NASDAQ -1.33%. There is substantially more invested in
ETFs that track the S&P 500 than the other two measures. The 1% difference
between the S&P and NASDAQ is of particular interest because in most market
declines one sees greater falls in the over the counter market than the listed
market, however the NASDAQ index had been stronger recently. Based on history
one would have expected the prices on NASDAQ to fall the most, followed by the
DJIA due to its heavier industry orientation and the least decline should have
been the market weighted S&P 500. I believe the difference was the amount
of money invested in ETFs in the S&P compared to others.
Why did some of the ETFs momentarily perform worse than the indices or their related mutual funds? Mutual funds have only one transaction price per day which is the closing price. ETFs are traded on the open market throughout the trading day. When one is dealing with the mutual fund it is a direct purchase or sale. With ETFs one goes through an Authorized Participant (AP). The APs are floor dealers that create or redeem $250,000 chunks of the fund. They get frequent intra day net asset values for the underlining fund. They use this to make bids and offers for those who wish to transact. Under normal market conditions the price differentials from the last known NAV is small, in part because there are other competitive APs. On Monday with a large number of large company stocks not open for trading there were not good NAVs to trade against. As a risk control measure the APs widened their bid/offer spreads and reacted to incoming orders. The price insensitive sellers were desperate to get immediate executions which used up much of the capital of the APs who could not off-load the redemptions fast enough to stay within their own capital constraints. Later in the day trading returned to more normal, but high volume day patterns.
In Summary
1. Be aware of co- venturers and the risks of them getting through the door first.
2. Understand the market mechanisms of what you own.
Next Week
I am currently planning on discussing what we learned about ourselves as investors last week.
Post-Script:
According to Blooomberg TV, Asian markets opened down, with DJIA futures off 214.
Question of the Week: What did you learn last week?
__________
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A.
Michael Lipper, C.F.A.,
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All Rights Reserved.
Contact author for limited redistribution permission.
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