How bad might it be?

Friday, 27th October 2017 10:29 - by Eric Chalker

If stock markets fall, what should we expect?  Our individual answers to this will differ, so it is not for me to make a forecast, but what if it is more than the simple ten per cent ‘correction’ that some are forecasting?  Sometimes markets reverse and then keep on falling.  What might such a reversal look like?

Two months ago I wrote about the increasing riskiness of current share prices (“An insistent drumbeat of increasing intensity” 25th Aug 2017).  The sound of this warning drumbeat has surely increased, but is still not reflected in equity prices (although profit warnings do seem to be carrying a sharper penalty).  There are voices still telling us to stay in the market because the greatest gains may yet be to come and this might seem wise if all we need to survive is a temporary ten per cent drop at some unknown date in the future.  Even so, as no-one will know once it has started quite where it will stop, it seems sensible to give some thought to a worse scenario.

Two factors strike me as particularly worthy of consideration.  One is the now major and still increasing use of exchange traded funds (ETFs) to buy equities, instead of choosing individual companies in which to invest.   The other is computer-driven trading, wholly dependent for buy and sell decisions on algorithms which react to events.  It appears to me that both factors are capable of magnifying any market downturn which, fearsomely, might in combination be more dramatic than anyone is anticipating. 

Panic risk

Most readers of this blog will have seen the 1983 film comedy “Trading Places”, starring Dan Aykroyd and Eddie Murphy.  It is worth a revisit, to see what happens to the price of frozen orange juice when fear takes over from greed.  Starting at 102, the price is driven up by rumour to a high of 142, but when reality kicks in it rapidly drops to 29.  This is fiction and the storyline depends on deliberate market manipulation, but the panic it shows is not unknown in the real world when confidence collapses, as it does from time to time.  In the film, the ‘true’ (undisturbed) price was still 102.

Investopedia defines an ETF as “a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.”  Wikipedia offers the most detailed explanations of ETFs, including their particular risks and criticisms of their effect.  There are suggestions that their growing popularity actually influences and can be used to manipulate the prices of their underlying investments, even contributing to the market collapse of 2008.  The IMF has warned “that leverage embedded in ETFs could pose fnancial stability risks if equity prices were to decline for a protracted period.”

As Wikipedia makes clear, ETFs have become popular because of the flexibility they provide, but I fear that this very flexibility – and its widespread use – has detached investors from what really provides true investment returns, namely real assets and human endeavour.  Putting money into an ETF is taking a ride on the back of money flows, not true investment.  It is going with the herd, not judging the future profitability of the underlying entity.  ETFs based on derivatives, inverse ETFs (betting on price declines) and leveraged ETFs offering several times the underlying asset movement (up or down) all further detach investors’ money (which, in the USA especially, may itself be borrowed) from anything of intrinsic value.

What happens when it goes wrong? 

Because ETFs are easy to buy, they should also be easy to sell.  Isn’t that the point?  In normal times this must surely be so, but in abnormal times?  

Every ETF involves an intermediary with the task of keeping the ETF value and underlying asset value in sync, by putting money into the assets or derivatives of them (the latter involving an additional intermediary).  So, the more money put into an ETF tracking an index, the more the index will rise.  Similarly when buying more of an individual company’s shares their price will rise, but those purchases are backing a business, whereas money put into an ETF tracking an index is backing an index, which is little more than other people’s behaviour.

When the process is reversed and prices are falling, the task facing the intermediary may be more challenging, because this will be market-related, not company related.   Selling individual company shares under pressure is one thing, but having to keep pace with a plunging index is likely to be difficult.  Buyers may have to be found for a large number of companies’ shares, simultaneously, in competition with other ETF providers doing the same thing, or derivatives nullified.  The value potential of individual companies, although likely to make direct investors pause for thought, will play no part in any mass sale of an ETF.  Any difficulties faced by an ETF intermediary in disposing of the related assets as money is withdrawn will add to the risk of a general market failure, which must surely be a possibility.

The principal market risk must be in the USA because its shares are the most overvalued, that’s where the greatest investor leverage is to be found and that’s where most ETFs are to be found.  History shows, however, that big movements over there will be reflected over here, so being invested only in the UK is no comfort.  What is a private investor to do if he or she is in fear of a market collapse?  My thoughts are these.

• Don’t put money into ETFs (or other ‘passives’).
• Keep shares which are justifiably being held for income.
• Keep shares with a sound prospect of strong growth.
• Sell shares which look over-valued and hold the cash instead.

If the market does fall

• Study the reasons.
• Make sell or hold judgements about company shares individually. 
• Be wary of a seemingly quick recovery, but keep an eye open for special situations.

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.