To say market volatility has been severe is an understatement, as investors cope with the economic and financial challenges of COVID-19. Monday’s 3,000-point plunge – more than 12 per cent – represented the second-worst day in the market’s 124-year history. Ferocious selling has fueled fear that perhaps the investing cognoscenti know something the rest of us don’t. We should keep in mind that not all selling occurs because investors anticipate market conditions will worsen. In fact, many investors have been forced to unload their positions regardless of their market outlooks: a cadre of institutional investors out there are hamstrung by their strategies and their decision rules, and must sell.
Margin debt has been contributing to volatility. Cheap financing and steady markets in recent years have prompted investors to load up on margin debt, leveraging low interest rates into generous returns on the way up. That same strategy is coming back to bite those hands that fed it for so long. Gold, after peaking on March 9, plunged 10 per cent in five trading days as investors raised cash to meet margin calls. According to NYSE and FINRA data, margin balances have expanded with the equity market’s advance, having the potential of transforming a market downturn into a rout as borrowers are forced to pay down their margin loans.
Writing puts, another strategy employed by institutional investors in recent years to enhance portfolio yield, is also exacerbating the selloff. Like selling insurance, put writers sell for a fee, or premium, the option to “put” (sell) them risky assets, like stocks, at a floor price that is often a few percentage points below current market values. Put writing, depending on the terms, historically has generated between two per cent and six per cent in premium income annually. The recent market downdraft and concomitant volatility spike forced put writers to sell stocks to offset their underwater option liabilities independent of where they think the market is headed.
Risk parity is a little more complicated but represents another institutional quantitative strategy involving programmatic buying and selling. Risk-parity strategies target a desired portfolio risk level, as defined by volatility, and adjusts its holdings dynamically to maintain the target. Last year’s low volatility prompted risk-parity strategies to add risk by selling lower-volatility bonds and buying higher-volatility stocks. This year’s selloff quickly reversed that strategy, forcing portfolio managers to dump stocks as market volatility approached levels not seen since the financial crisis. It is estimated that risk-parity funds manage $175 billion, according to a recent report in The Wall Street Journal. Traders overseeing risk-parity strategies manage for risk, not profits, at least in the near term, taking their cues from trends in volatility, not changing outlooks.
Sellers sell for many reasons, not all of them related to dour outlooks or to the belief the market is headed lower. The first selloff I witnessed as a professional (albeit junior) trader was on October 19, 1987, when I learned that Black Friday’s 20 per cent plunge was exacerbated by program trading algorithms and not necessarily pessimistic outlooks. The fall was gut-wrenching, but the market fully recovered its drawdown 18 months later. Watching red screens and market downdrafts is never easy, but having the luxury to hold affords goals-based investors the opportunity to take a deep breath and a step back, and to manage for their investment horizon without having to worry about the potholes along the way.
Looking at S&P 500 returns going back 50 years, the probability of making money owning stocks for 1 day was a virtual coin flip. Extending your holding period to 1 year improved your chances to 80 per cent. Investors willing to hold for 7 years had a 99 per cent chance of making money. While the past is not necessarily prologue, all other things being equal, patience is not only a virtue, it’s an advantage.
S&P 500 Rolling Holding Periods 1970-Today
Source: Standard & Poor’s; Cresset Capital.