By Anthony Harrington
It is not unusual for investors to find the markets moving in ways that seem to defy common sense. Companies often feel the same way. They announce good results, they have a great product pipeline and plenty of cash in the bank, and the stock price falls off a cliff. The directors throw up their hands and wonder what on earth the markets expect from them.
Some lose patience and initiate moves to delist to free themselves from the yoke of trying to please an irrational tyrant. Others simply sigh and resign themselves to waiting for sanity to return to market pricing, bearing in mind Keynes' famous dictum as they do so. Just in case there is anyone out there who cannot instantly recall said dictum, Keynes' warning was that "the markets can remain irrational for longer than you can remain solvent." That's just another way, actually, of saying don't bet on the bottom until it bottoms. Just because you think a stock is priced too low doesn't mean it's going to go up anytime soon -- and it may go lower still.
However, what looks to be irrational or at best understandable as a wild amplification of a minor negative -- something markets can do from time to time as investors overreact and "herd behavior" sets in -- can occasionally have a more rational explanation. Apple (NASDAQ:AAPL) provides an excellent case in point. The stock has a long history of soaring rallies and massive sell-offs. Why is this important? As arguably the most successful and iconic company in America, and as a company that has a reputation for rewarding buy-and-hold investors if they can ride out its price troughs, Apple is a major component in the portfolios of big institutional funds across advanced markets. Fund managers know that by maximizing their allocation to Apple, they are giving themselves a very good chance of outperforming over the medium term.
In an excellent article featured in Seeking Alpha, Jason Schwarz points out that the key to understanding Apple's huge sell-offs from time to time lies in the fact that most fund managers will have a rule that says that any single stock cannot be more than a certain percent of their total portfolio. The reason for this is to honor the idea of diversification as the best way of protecting capital. If you follow this idea of a restriction on the percentage any one stock can have allocated to it, then it follows that when Apple is doing one of its major run-ups, adding very substantially to its price, as happened when it went from $500 to $700, the total value of Apple holdings in many fund portfolios rapidly exceeded the allowed allocation. So the fund managers have to rebalance their portfolios by selling off a chunk of Apple stock to bring the allocation to Apple back within their policy constraints.
If just one fund manager does this, in general unless they are holding vast amounts of Apple stock, it makes no difference to Apple's share price. However, since, as we have said, holding Apple is a winning strategy for so many funds, what happens when Apple's price roars up is that a number of funds get pushed over their single stock allocation for Apple, and they all tend to get pushed at about the same moment. So the inevitable result is a sudden glut of Apple selling with large amounts of stock coming on to the market, driving the price down. As this happens, other managers who might not be over their allocation, but who have done very nicely from Apple through the run-up, decide to sell and take profit -- knowing that in all probability, they will be able to pick up those same shares at a discount a bit further down the line. (Sell, wait for the price to drop sufficiently, then buy again before the next up-cycle kicks in.) The net result of all this is that Apple's price plunges even although all the fundamentals are good:
Suppose you were a mutual fund manager and your strategic models allowed for a maximum 8% allocation in any individual stock. What would have happened to your Apple holdings in 2012? As of Sept. 21, Apple was up 74.9% year to date. Apple allocations at the largest mutual funds had grown to between 13% and 15% of total holdings with the fiscal year end approaching on Oct. 31. Because of Apple's strength, because it was such an outlier when compared to the rest of the market, these money managers were forced to rebalance their portfolios in order to comply with their risk models. The Apple slingshots, or in other words the deeper than unexpected sell-offs, are caused by systematic institutional rebalancing.
That is it in a nutshell, Schwarz says. Forget conspiracy theories about hedge funds, forget any number of "trigger" events for the sell-off that are touted in the press -- rebalancing is the real driver. And once the institutions have finished rebalancing, and the ripple effect from that rebalancing has died away, Apple will be on the rise once again.