October Mayhem: Why a Global Selloff May Be Imminent?

 |  Includes: DIA, EWH, FXI, INP, IVV, PGJ, SDS, SPY
by: Enzio von Pfeil

With markets wobbling since last Friday, we wanted to put current events into past perspectives. Things are not as “different” as some people wish that they were.

Perhaps for too long, The Economic Clock™ has been showing danger signals. In an absolute sense, we have erred: the US and European markets have continued performing. But, in a relative sense, we also have suggested that The Economic Time has remained superior to these two developed economies for the likes of China, (and thus Hong Kong) and India, who have outperformed the G-2 massively.

Chaos, and thus market crashes, are by definition unpredictable. Even behavioral finance cannot explain why chaos arises; this school can only identify what “the herd” does when chaos hits.

1. Portfolio insurance, or “pass the hot potato”?

However, the marvelous Financial Times (NYSE:FT) of the past few days raises an interesting point: in 1987, as now, portfolio insurance has exacerbated risk, instead of limiting it, as such instruments are supposed to do. Here are some key points on portfolio insurance:

· Its goal is to protect investors from downside losses. More appropriately, however, Gillian Tett of the FT has dubbed such insurance a “risk transfer gospel”.

· How: futures contracts are bought as insurance against falling equities prices.

· Why it has backfired: “But the strategy broke down because it relied on adding more protection as the market declined. This only aggravated the market’s fall, as would-be insurers all tried to short the market at once.” So, everyone headed for the exit at the same time: everyone sold stocks and bought futures.

· This time around, such insurance has mushroomed – and the risk has been spread across markets. This is not only because markets are becoming more accessible, but also because investors – corporate and individuals alike – have increased their leverage massively. This has at least two consequences:

o Risks more spread out. For instance, in the first half of this year, the equity derivatives market grew by 39%, to USD 10 trillion. This is because “Investors can now boost their exposures to equities and try to protect their portfolios against sharp losses through the use of futures, options and a plethora of equity derivatives such as total–return swaps and options on volatility.” (FT, 19th October 2007), and

o Size ballooned. Add to this mushrooming of “insurance” the observation that the lack of communication during the 1987 crash spawned electronic trading. The results: the average daily trading volume on the New York Stock Exchange [NYSE] has risen about ten – fold since 1987, to 1.8 billion shares; meanwhile, the combined market capitalization of shares listed on the NYSE has grown fourteen–fold, reaching US$28,000 billion.

· The result this summer. With ever–more derivatives issued, and with ever–more trading done, the subprime mess of the past summer has boiled down to a game of “pass the potato”. The degree of risk “out there” cannot be measured any more, recent bail out packages suggested, by U.S. Treasury Secretary Hank Paulson of all people!

2. Why October?

Churchill taught that the further back you can look, the further forward you can peer. So for those of us who like past dates, here is a short jaunt down “October crash lane” (FT, 13th – 14th October 2007):

· 28 - 29/10/29: the Dow Jones Industrial Average [DJIA] fell 25% over these two days – and that heralded the global Great Depression.

· “Black Monday”, 19/10/87: the DJIA fell by 23% in one day.

· 27/10/97: the worst day of the Asian crisis forced the New York Stock Exchange to shut down early in reaction to the weight of selling.

According to the FT of 19th October 2007, there are two reasons why investor vulnerability rises in October:

o Closing out. Meanwhile, October is when most American mutual funds close-out their fiscal years. They do this in order to send “…investors a notices of their capital gains or losses before the personal tax year closes at the end of December.” This “tax adjustment” gets nasty if investors have to realize losses on their investments, and

o Forward focus. October is reporting season for most companies – in which they provide their outlook for the coming year. Thus, investors start focusing on the coming year’s outlook. With The Economic Time worsening in the G-3, companies will be gloomier about their profits prospects – and this continues souring investor sentiment.

3. Why this October?

We already discussed this earlier on. Here is an update in which we also refer to the FT’s John Authers “Long View” of 13th – 14th October 2007:

· Auspicious October. As we suggested just now: October is when risks “bunch” – especially in the “07” years;

· Stock bunching. Market advances increasingly have focused on pushing individual stocks – which act as the “mule” pulling the market;

· Sector bunching. Investors have been chasing particular sectors – thus increasing their vulnerability to a sudden sell–off;

· Asia–bunching. The abnormally strong rises in China and thus in Hong Kong over the past weeks are food for thought. While we, too, believe the China story, the market run – up has been exceptional;

· Decliners > advancers. In the major indices, there are more stocks falling than there are rising, and thus

· “Put” option emphasis. Increasingly, people are buying “portfolio insurance” by acquiring the right to sell stock at a pre-agreed price. This suggests that “the herd” senses market declines.