Following the market plunges after 9/11 and the 2008 financial crisis, I did not change my investment strategy of regularly buying into stock index funds.
This week, the Dow and S&P dropped 12% and 11%, respectively, according to CNBC. In response, I will do the same thing as I did before.
Yet there is something different going on with the latest crash: I have no idea why it happened.
So far, the explanation that makes the most sense to me is that computer-driven trading triggered by a complex hedging strategy is responsible for the crash. But that explanation leaves me with many unanswered questions.
Why did stocks keep climbing after news of the Coronavirus in China broke last December?
I am sure that the selloff was not triggered by the world becoming aware of the Coronavirus — COVID-19. If that was the cause, the crash would have happened on December 31, 2019 when cases were first reported by Chinese authorities, according to the Washington Post.
While it has been reported that the selloff was triggered by reports that COVID-19 cases were appearing outside China, according to the Wall Street Journal, I did not find that explanation very satisfying.
All the hedge funds dedicated to beating the market could surely have anticipated that the virus would not be contained to China. As I wrote February 3, in January Goldman Sachs predicted the Coronavirus’s economic impact. Given the rapidly-changing nature of the threat, smart investors would have recognized that there was considerable uncertainty in that forecast.
Indeed, MIT expert Richard Larson told me that over-reaction to Coronavirus could cause the biggest economic impact. Meanwhile, the S&P 500 kept rising most of the month to peak at 3,386 on February 19. Since then, stocks have lost $4.6 trillion in value, according to Barron’s.
How serious is the potential economic impact of COVID-19?
Since not much is known about COVID-19, it makes sense to forecast different scenarios. According to the February 29th Economist, the worst case scenario — similar to the 1918-19 drop in GDP resulting from the Spanish Flu — about what happened in the 2009 financial crisis — a 5% drop in GDP.
This is based on a 2006 economic model of an influenza pandemic created by Warwick McKibbin and Alexandra Sidorenko, both then at Australian National University. The Economist reported that their “mild” scenario is for a mere 0.8% drop in global GDP — assuming that 30% of people are infected, losing on average ten days’ work each, and a fatality rate of 0.25%. The mild scenario would trim a quarter of the global growth previously forecast for 2020.
McKibbin thinks that the model’s “moderate” scenario — a 2% hit to global growth — best fits COVID-19. That is worse than the forecast from Oxford Economics — which expects COVID-19 to cut 1.3% from global GDP.
Anecdotal evidence — e.g., companies like Microsoft reporting that COVID-19 would make it impossible to meet first quarter revenue guidance, according to CNBC — suggests reasons for concern in some stocks.
However, I think a smart investor would realize that a temporary slowdown in production due to supply chain interruptions would be made up in future quarters once COVID-19 is under control.
Moreover, if these economic forecasts are accurate and the world’s economic growth takes a 1.3% to 2% hit as a result of COVID-19, this week’s market correction seems vastly overblown.
How did computer-driven trading contribute to the stock plunge?
To understand why the markets overshot, it helps to look at Wall Street’s so-called fear gauge — the Cboe Volatility Index (VIX).
When word of China’s coronavirus was first reported on December 31, the VIX was at 13.78, according to the Cboe. On February 19 — when the S&P 500 peaked — it had risen slightly to 14.38.
From there, markets plunged and the VIX spiked. By February 28, it had more than tripled to 49.15, its highest intraday level since February 2018, according to CNBC.
Computer-driven trading linked to a spike in the VIX is probably responsible for the waves of selling that wiped 12% from stocks during the week. Unfortunately, I could not find out how much of this week’s trading volume was due to these hedging trades.
The Journal reported that a large amount of trading — more than $100 billion in selling February 24 and 25 — “was fueled by options hedging and trading strategies based on market volatility” according to Marko Kolanovic, global head of quantitative and derivatives strategy at JPMorgan Chase, who said that investors’ ability to get in and out of positions also worsened this week.
Options trading strategies put in place by hedge funds and other institutional investors have triggered computers to sell more stock as prices fell. As the Journal reported, one such strategy — so-called short gamma positioning — pushed prices down abruptly during the week.
Traders sold more stock as prices dropped due to Gamma — which “measures how much the price of an option accelerates when the price of the underlying security shifts,” noted the Journal. Charlie McElligott, a cross-asset macro strategist at Nomura, wrote that “Dealers are in the ‘short Gamma’ zone, and that added to the move to the downside [Monday], as they generically speaking were sellers the lower we traveled.”
For every percentage point that the S&P 500 dropped, SqueezeMetrics estimated that tens of billions of dollars of S&P 500 futures had to be sold.
Here’s how the trade works. Investors buy S&P 500 put options — which give them the right, but not the obligation to sell the S&P 500 at a specific price at a future date — from options dealers, who take the other side of the trade. The put options rise in value for the investor as the S&P 500 plunges while losing money for the seller.
Why is there pressure to sell stock as that put option is rising in value? As the Journal wrote, “Professional options dealers try to maintain neutral positions in the market and remain constantly hedged. As markets fall, options dealers sell stocks or stock futures to offset those positions. The selling can intensify the more stocks fall.”
The profits in this trade attracted other investors who decided to bet on the increase in the VIX – -using an an exchange-traded product tied to VIX derivatives. This week VIX-related options volumes “hit the highest level since May,” according to the Journal.
The market physics of this options-linked trading could also send stocks soaring. The same selling- begets-selling dynamic that send stocks down can send them soaring if prices rise. That’s because to stay hedged, options dealers may have to buy stocks as they rise.
While uncertainty about COVID-19’s economic impact remains high, fear of a plunge in fear could send stocks back up in the weeks ahead.
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