Global stock markets dropped sharply on Thursday, September 3, with mega-cap technology stocks accelerating their slide from the previous day. Various speakers from the Federal Reserve likely exacerbated nervousness among investors, with the presidents of the Chicago and Atlanta Federal Reserve branches publicly expressing concerns about asset bubbles and recent stock market performance.
While the 3.51% and 4.96% losses in the S&P 500 and NASDAQ Composite on Thursday may have suggested the selloff spared no stocks, about 19% of stocks were advancing, and 25% of NYSE trading volume was going into stocks that were rising in price. It was previously leading sectors, such as technology, that bore the brunt of selling, while previous laggards fared rather well. For example, the NYSE ARCA Computer Technology and Networking Indices dropped 6.11% and 7.80% on Thursday while the NYSE Banks, Oil Services, and Utilities Indices only fell 0.78%, 0.36%, and 1.31%, respectively. Airlines actually gained 0.14%. Overall, Wednesday’s and Thursday’s market action seemed less characteristic of a broad market selloff than of a short-term washout of overly popular stocks that may have risen too far, too fast.
It May Have Started with Tesla
In a year when global stocks have barely been able to break even, Tesla had climbed over 480%. In addition to making Elon Musk become the world’s third-richest person, Tesla’s pop has made it a natural overweight in many portfolios. Let me explain. If 10% of my portfolio is in Tesla, and the other 90% is in other stocks that have broken even, a 480% increase in Tesla’s stock price will make Tesla represent 34.8% of my portfolio. Naturally, many institutions have mandates to diversify and not hold overly large positions in any one stock, so they may need to trim their holdings of stocks that are sharply rising.
That’s what happened to Tesla on September 2 when Ballie Gifford (a major investment firm and Tesla’s largest outside shareholder) had to sell some of its stake in Tesla, triggering the stock to tumble. This dragged down the rest of the tech-heavy NASDAQ Composite Index through the end of the week.
What I Think Happened – It Was the Quants & Hedge Funds
In “What Happened to the Quants in August 2007,” financial theorists Andrew Lo and Amir Khandani propose that institutions such as hedge funds and long/short funds tend to pile into the same baskets of individual stocks. They also use leverage, meaning they borrow money to invest in certain stocks, making these funds very sensitive to price changes of these stocks. Therefore, when one or more of these stocks has an unusually bad day, it may trigger multiple hedge funds to need to sell out of their positions at once, causing violent short-term declines.
This happens rather frequently (there have been a couple of instances every year over the last decade), and a typical characteristic of these “hedge fund panics” is that the stocks that dropped during the panic typically recover over the next few days as these same funds buy back into old positions, but with less leverage. The August 2007 panic, for instance, lasted three days before there was a substantial recovery. Thus far, the position unwinds this week appear to be far less fierce than those observed in 2007 and, for those who read the Lo/Khandani paper, 1998.
Does It Say Anything about the Health of Markets?
Overall, these types of panics have not historically warned of any sort of larger market calamity. It seems like they are a natural way of clearing out excesses, which in this case are overleveraged institutional investors. Similarly, these unwinds have not been reliable warnings of longer term changes in market leadership, say, from leading sectors such as technology to lagging sectors like finance. Some panics have historically been followed by new market highs, and others by further losses. Altogether, the performance patterns following these types of hedge fund panics are seemingly random.
What isn’t random is what we have been discussing internally: that the stock market was overbought and had been led higher by a small cadre of technology stocks since August 12. In other words, this market has been due for some sort of short-term pullback. Also, September is seasonally the weakest month of the year, with the S&P 500 averaging a monthly 0.57% loss since 1950. But just like breathing in and out, short-term market volatility is natural, and our indicators are currently not warning of any larger, more protracted breakdowns in global equity markets. Therefore, we are largely recommending clients stay the course and remain committed to longer-term investment plans, expecting some chop through September as the market works off its overbought conditions. Then, as all eyes turn to the election in November, we will be sure to pay extra attention to our various proprietary warning systems, making adjustments if and when needed.