“Making Sense of Market Volatility”

No doubt most of you would have seen the headlines the past couple of weeks as markets rose and fell quite dramatically.  While we agree there will be financial impacts felt by the global economy, we can’t help but think that investors are behaving in a similar fashion to those swarming the grocery stores clambering for toilet paper and Lysol wipes.   Certain companies and sectors that rely heavily on travel and tourism (see our recent post discussing these industries) have been rightly “sold off”, but we also see companies that should have little to no affects from the Corona Virus being treated in the same fashion.

Additionally, Russia and Saudi Arabia have declared an oil price war and while that may mean lower gas prices across the US, it will also mean oil companies (small and large) will see their margins get squeezed.  Also, if fewer people are traveling because of the virus, then the benefit of lower oil might not have a big effect for travel that we normally see.  It might not be fun watching or reading these headlines, but it’s important to approach these volatile times with a level head and heart.  We wanted to run through a few reasons why we are seeing such large gains and losses and why we don’t believe you should be running for the door.

Many Individuals are highly leveraged after a long bull market

Over the past 11 years, the market has experienced an incredible run and has encouraged investors to take on debt to increase their positions and in turn leverage their returns.  This type of approach can work well when the market is moving up, but rather than being satisfied with their returns they have used equity created to buy even more.  When we see a rapid decrease in markets like what has occurred recently, it means these “leveraged individuals” experience a “margin call”.  In other words they either inject MORE capital to bring their leverage down OR sell their holdings to reduce their debt levels.  Most investors are nervous and/or don’t have the extra capital so they are forced to sell all of their holdings to fund their margin call.  It is a dangerous game they play and they are now getting caught out.

Computers Are Calling the Shots

In 2019, algorithmic trading made up approximately 80% of all trades in the United States. This style of trading is generated by computers that use advanced mathematical models to make high speed trading decisions. Think of a rules-based system where when something occurs in the market a computer will react (either buying or selling shares) based on what has been programmed into their system. The computer doesn’t have a true understanding of why a specific event is occurring in the market, just that it must react. When you see large selling like what has occurred due to Reason 1 the computers don’t know what the Corona Virus is or that many investors are selling to cover margin calls.  There rapid response is many times what causes the speed of the increases or drops we have seen in the past couple of weeks.

Index Funds are More Owned Than Ever

Over the past 10 years, index fund ownership has doubled in the United States.  Before this rise of index funds, if we saw an event like these past weeks occurring, and you needed to sell some of your portfolio, you would look through the list and sell off the dogs and keep your best performers. Now with index funds comprising such a large portion of investors’ portfolios in the US, we don’t have that luxury. For example, if you owned an S&P 500 index fund and you wanted to take some money off of the table in the past couple of weeks you would sell a portion of the fund you hold which is essentially selling a small piece of ALL 500 companies on the index.  A sale of this type of fund means it’s a one-in-all-in approach and the good companies get sold with the bad.

As part of our overarching approach for client accounts, we always hold a portion in cash and “fixed income” securities to ensure we are prepared for times like these.  When markets are volatile like they are right now, it means we can lean more heavily on the steadiness of fixed income while we give the stocks in the portfolio time to recover.

March 13th, 2020