1987 and all that ... a lesson from history ignored ?
ref :- "Momentum surfers revive painful memories" , the Financial Times, Markets and Investing
1987 will seem like an awful long time ago to younger readers ..... not for all of us, sadly. But whatever your age or level of experience, only a fool ignores the lessons of the past. You might conclude then that foolishness must be an intrinsic component of the human condition, so often do we repeat the mistakes of previous generations.
But we're not here to discuss weighty philosophical issues, and all will relieved to hear that. Rather, we'll stick to the much lower-brow subject of markets ..... and in particular the stock market crash of 1987. The question the FT poses is whether, after another extended bull-run in equities, we have in effect reinvented the tools that many believe contributed hugely to that disastrous market blood-letting of thirty years ago that knocked 20% off the S&P in a day, for example. The gist of the article is that not only have we reinvented those tools, we have conveniently re-named them and are using them in much the same way.
Back then, the buzz-word was "Portfolio Insurance". Designed just over a decade earlier and based on the principle that what's going up tends to go up further and what's going down continues to fall , portfolio insurance used momentum indicators generated by computers to add to, or in this instance much more importantly to reduce, the size of an investment as the market changed direction. The trouble was that it assumed relatively normal market conditions in which to trade (ironic as they were instrumental in creating abnormal conditions), and that instead of adjusting the level of holdings in individual stocks many systems used futures on the S&P Index to hedge against losses on the portfolio instead. In practice it was much faster, easier and cheaper to sell futures as the market fell than to attempt to do the same with a large number of different equities in a fast moving market. It also transpired that many of the advisers running this form of insurance did not have the authority to trade clients' cash stocks, and were forced to hedge on the futures markets even if they didn't want to (they mostly did, of course).
The theory of course was simple : what you may lose on the cash stocks, you get back on the short futures positions -- or at least a large part of it. The reality was very different. One of the problems with computer-generated signals, then as now, is that they are generally very similar, which means that participants are all trying to do the same thing at the same time and there's no one to be found to take the other side of the trade. With few buyers to absorb the selling and stop-loss sell orders being triggered at every turn, the market had quickly fallen out of sight with little trading actually being struck. In the post-mortem conducted into the crash, it was adjudged that the relentless selling pressure exerted by programmed portfolio insurance funds had greatly worsened the crash -- the very thing they were designed to prevent.
It couldn't happen again, could it ? Stocks are at or near record highs, and although the names may have changed, institutional investors are increasingly allocating money to "risk mitigation" or "crisis risk offset" programmes. Like other vehicles before them, these are designed to hedge losses should the market reverse sharply and mostly comprise long-maturity government bonds and trend-following hedge funds -- these tend to do well when equities drop.
Anyway, to continue and to quote the FT : "These trend-following hedge funds .... are commodity trading advisers (CTAs), sometimes called managed futures funds. CTAs are computer-driven vehicles that take advantage of markets' tendency to momentum". Sound familiar, anyone ? To some in the industry, these new programmes are portfolio insurance by another name, and if the CTA's are more advanced than their 1987 predecessors, that takes no account of the fact that complex financial markets are constantly evolving too. It's all very well urging people towards the more sophisticated and therefore more expensive products on offer , but you can be sure that plenty of people won't be using them. And if the size of the problem is small, as some would have it, it's definitely growing.
Read the article ..... it sounds eerily and uncomfortably prescient.