It's Gonna Be Worse

The next market downturn has the potential to be longer and deeper than we have ever seen before.

A lesson from the flash crash of August 24, 2015.

On August 24, 2015, disappointing Chinese economic data resulted in the overnight Chinese markets falling 8%. This spooked markets around the world and before the US market opened the US traders started pulling their buy orders and put in sell orders instead. With an overwhelming number of sell orders, pulled buy orders, and no buyers – many stocks did not have an opening bid. The S&P index dropped 5% in the opening minutes of trading.

Electronically traded funds and passively managed portfolios trade indiscriminately. If you owned such a fund and put in a market sell order, the fund would start to sell all the stocks in that fund/index … the stocks with opening bids and the stocks with no opening bid.

So, while the market was down 5%, the loss was much greater for some broadly-held ETFs. The “low-volatility” ETF offered by PowerShares was one of the hardest hit – down 46%. This occurred despite the circuit-breakers that were in place - stocks and ETFs were automatically halted more than 1,200 times that day. The most troubling part? Experts still can’t agree on what actually happened! Chances are, this could easily happen again. They haven’t fixed the problem that indiscriminate selling from passively managed portfolios creates.

Why is the ETF, that tracks the S&P 500 down 46% when the index is only down 5%? Because the underlying stocks in the ETF have not opened for trading. The order will be filled by some institutional investor who has a low-ball bid in. Investor thinks they’ve lost 5% of their money and they’ve lost close to half. In a mutual fund or segregated fund, you get end of day pricing. You’re not exposed to this.

ETFs trade like stocks during the day. The problem is they may have to sell stocks that have no opening bid, pushing markets down drastically. There is currently no solution for this. And very few investors in passive funds have an understanding of the tremendous risk they are exposed to.

I believe the next market crash has the potential to be significantly worse than the financial crisis of 2008. The growth of passively managed money in Canada and world wide as been tremendous over the last 9 years. Funds that buy the index without regard for price or earnings have pushed markets to new highs throughout 2017. It has pushed up poorer quality stocks beyond reasonable valuations. And when they have to sell stocks … again without regard to price or value … we may very well see market loses across the world much more severe than in 2008.

Talk to me today about scheduling a defensive portfolio review.

For more information on the impact of passively managed money on markets and investment returns read The Case For Active management, The Upcoming Market Crash, Are you swimming naked?, In Case You Forgot Rule Number One, Is This Your Doctor?, & You're Behaving Badly.

Source:   Empire Life

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