How Hedge Funds, Computers, And Margin Borrowing Cause Volatility Extremes

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Includes: DIA, IWM, QQQ, SPY
by: William Darusmont

Summary

All of these involve algorithms which are totally devoid of emotion.

They cannot reason as a human being (especially a market veteran), and just do as programmed.

Have we gone from a secular bull market which began in 2010 to a secular bear market?

The first hedge funds appeared in the 1940's. Since there were no computers they were pretty simple long/short funds. Say it's earnings season and you thought GM would surprise to the upside and Ford (NYSE:F), would miss on earnings. Take equal amounts of dollars and go long GM and short Ford, then, after the event cover both positions and look for the next opportunity.

For the same reasons, margin borrowing was of little interest, except to those who had borrowed.

Here is a table of data from the NYSE on margin borrowing. For now, just look at it:

Margin Borrowing Billions

     

Year

Low

High

     

2015

444.8

507.2

H Nov.

   

2014

437.1

465.7

     

2013

364.1

444.9

     

2012

276.5

330.4

     

2011

262.1

320.7

     

2010

231.1

276.6

   

2009

173.3

231.8

L Feb/H Oct-Dec

 

2008

186.7

334.9

H Dec

   

2007

285.8

381.4

H Jul

   

2006

222.8

270.5

     

2005

194.6

221.7

     

2004

177.0

203.8

     

2003

134.0

172.1

     

2002

130.2

150.9

     

2001

144.7

197.1

     

2000

198.8

278.5

L Dec/H Mar

 

1999

151.5

228.5

L Feb/H Dec

 

1998

127.8

154.4

L Feb/H May/LTCM Oct

Pre-1998 : 150M ave

         
Click to enlarge

Starting with the 1987 Crash…remember it was the dotcom bust. All of those stocks were traded on NASDAQ. That also marked the first time that a company could do an IPO without having five years of financials and making a profit in two (usual rule). But with the dotcoms came massive speculation and the advent of large numbers of day traders. But since NASDAQ stocks were not marginable, it had little or no impact on margin borrowing (note that includes both long and short borrowing).

I never paid much attention to borrowing until early 1999 when I was researching something in Federal Reserve Bulletins. I stumbled across a statement where on a trial basis six NASDAQ stocks would be eligible for margin borrowing to see if they had any effect on the market. I don't recall them but am pretty sure it included MSFT, INTC, and a few other major ones. Coming back some time later I noticed a big surge in margin borrowing in early 1999. The reason? Fed Chairman Greenspan did not like to see big investors borrow cheaper than small ones so following the test, the Board made ALL NASDAQ listed stocks marginable - starting on the day of the IPO! I was shocked at this…especially with Greenspan having just taken office when the 1987 Crash occurred. It left me scratching my head as the initial months saw a big increase. Note that in late 1998 following the Russian Ruble Crisis, Long Term Capital Management (LTCM) began to implode and Greenspan who had been close to raising interest rates reversed and slashed them.

Sometime in early 2000, I was a guest of the San Francisco Bond Club at a tour of the San Francisco Fed which ended with lunch and a speech from the President, Robert Parry. Following the speech in the Q and A, I asked this question:

"Why didn't Greenspan raise margin interest rates in 1999 to curb speculation?

Parry responded that Chairman Greenspan felt that all borrowers should have access to markets.

A long pause while I recovered since that is not his job, and followed up with this:

"Okay, but why did he increase margin borrowing by making all NASDAQ stocks marginable - from the day of the IPO?

Silence…deafening silence as I sunk in my chair feeling the stares of my peers as Parry asked, "Are you sure about that?" Remember this was a sitting member of the FOMC. I squeaked out, "Pretty sure."

As soon as I got back to my office I raced to the library and found the reference and faxed it to him. A few minutes later it came back with this comment: "oh, that." It seemed pretty obvious to me that he didn't know it.

Following Y2k, the markets continued their rally but this time not so much with American money which was pretty much committed but huge sums of European money flowed in…just in time to create a peak and start to decline. This resulted in the Tech Wreck which dragged down an entire market. Note on the table the trough and peak of margin borrowing in 2000. Then see the buildup to the 2007 peak and a new record in July, then the plunge of more than a 50% decline that didn't resume until very late 2008 just ahead of the broad market rally that continued through 2014. Finally see the all-time record high borrowing in November 2015…which should explain much of what has happened this year.

As the market sold off, hedge funds were met with large redemptions as were mutual funds. Following a pretty flat 2015, the exit was very narrow. As always in a major correction (or worse), you sell what you can sell with the least amount of loss, but as a manager the prudent thing is to 'run ahead' of the redemptions to protect the fund from the next wave. That is what we just came through. Will they come back? Not likely in any appreciable way. The reason it the 2% +20% fee structure which also includes a 'high water mark' clause. Thus it will be a long time before the managers will collect that 20% again so the best thing for them is to return capital to shareholders...and then emerge at some point with a 'new' fund with no high water mark.

Whether a hedge fund, a robo advisor, high frequency trader, or any computer-driven model, everything revolves around algorithms. Remember, computers are dumb…they only do what they are told too and when there is a rapid sell-off, as happened in 1987 and in 2010 and 2015 "Flash Crash", computers simply trigger selling because they are incapable of sensing human emotions. Regardless of the trigger points, these algorithms are not that different and drive volatility to the moon.

But in contrast to a 'flash crash' where suspending trading through circuit breakers can 'minimize' the damage, in a rapid decline as we have seen thus far this year, only time can create the liquidity to provide a sustainable rally.

I have found a valuable resource at Crestmont Research. I urge you to make use of the enormous volume of data they provide. It's much better than many fee-based websites. They have done a lot of research as to whether we are entering a new secular bear market. Based on the p/e ratios which were high, but not at critical highs, this could be simply a market correction. To me, however, this feels like something else. I sense fear and when that happens people move to the sidelines. Beware of quick rallies like we had on the last Friday of January, and last Friday. The magnitude of the decline in such a short period of time with several opening 'gaps' that have yet to be filled indicates a need for caution -extreme caution.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.