Thursday marks the anniversary of the blackest day in Wall Street, when the US stock market fell by more than 20 per cent.
The three-decade anniversary of the event known as Black Monday has understandably sharpened debate about whether the long-running bull market is ripe for correction. Beyond the argument about whether a bear market looms, there is another big issue for Wall Street to consider on the anniversary. Huge changes in the structure of the US market raise the important question of whether equities are more or less prone to a sudden, extreme accident such as Black Monday.
The rise of passive investing
The growth of passive investing, offered widely through exchange traded funds, leads the list of changes in how markets work that have aroused most concern. This development, which has happened almost entirely since 1987, is viewed variously as a potential disaster and a measure that could calm the markets.
Art Cashin, the veteran trader who runs NYSE floor operations for UBS, says: “ETFs as a concept and passive investing as a concept by their very nature make the market less efficient. Efficient market theory says that millions of people doing research following every movement of every company is how they come close to predicting earnings.
“If you are buying an ETF or passive investment in an index, you are not doing that kind of research. ETFs and passive investments by their very nature are beginning to build inefficiency in the market and that I don’t not believe will be resolved happily.”
Others disagree. Jeremy Grantham, the founder of the GMO fund management group, suggests that passive investing has yielded positive side-effects: “The irony about index funds and ETFs which are gathering so many assets is that they do spread the money around. The money is more dangerous when it is concentrated. When you spread the money broadly, the market tends to have a better structure and be less vulnerable.”
Portfolio insurance, a popular risk-management system that obliged traders to sell index futures into a falling market, was central to the way in which Black Monday turned into such an extreme event. Three decades on, risk-management practices have proliferated. But have they improved?
Asked if there are modern equivalents to portfolio insurance, Mr Grantham says: “Yes there are, but they are better worked out, more polished and the people who use them better understand them. Anything is possible, but the market is probably more resilient to modern equity hedging than it was to that crude rapidly expanding portfolio insurance in 1987. You could hear it creaking.”
The issue that concerns Mark Lapolla, who was at Goldman Sachs 30 years ago and now runs Sixth Man Research, is that all risk-management tools are based ultimately on the same group of assumptions — modern portfolio theory, the capital asset pricing model, the Black-Litterman approach and so on. “ . . . What happens when the risk environment changes and all strategists suggest making the same movement? It syncopates — and they’d trade ETFs to do it. That’s the way that’s easiest for people to execute. So we have portfolio insurance through portfolio management, using ETFs.”
Another key change is that exchanges are no longer a series of protected monopolies. Trading carries on in numerous venues, and that could be a problem.
Laszlo Birinyi, founder of Birinyi Associates and a veteran of Salomon, says Black Monday was “gut-wrenching” but at least it was possible to discern what was going on. “Now, with so many trading venues, and with much greater speed, that is no longer possible.’’
Central bank puts
Regulatory changes since the 2008 crisis have left banks far less enthused to make a market in bonds. The current era of ultra-low bond yields has been a boon for equities, and so the risk of a sharp rise in yields could knock both markets.
The implications are that we need not worry too much about a market accident while rates stay this low. Once they rise, and cash begins to offer some kind of a positive return, the risks for stocks and bonds would grow greatly.
Then there is the related issue of moral hazard. Investors experienced almighty market breaks in 2000 and 2008 and a number of other times when the market flirted with collapse. And yet all has ended well, with US stocks at record highs. Central banks have intervened to help asset prices throughout the period.
Rob Arnott, chairman of Research Affiliates, says: “We have central bank interventions that are much more aggressive than they were back then. [Alan] Greenspan intervened on crash day and it was a very aggressive intervention that came as a complete surprise. Today everyone would expect it.”
Finally, no issue divides opinion more than the risks and opportunities of computerised trading. Behavioural finance has shown the advantages, as computers do not suffer from the same flaws of reasoning and mental heuristics that humans do. That offers them an advantage most of the time but what would happen in a crisis?
Andrew Ang, who leads BlackRock’s move into factor investing, comments: “It’s all about timeframes. What is the window? If you are looking at a one- or five-year timeline then a market crash could be a great opportunity. But if your window is shorter, that could dictate how you react.”
Andrew Lo, finance professor at Massachusetts Institute of Technology and author of Adaptive Markets, goes further, pointing out that the rise of computerised trading should be modelled as a change in the market “ecosystem”. He says: “We really need to spend more time thinking about how that system has changed and model it as an ecologist would model a new ecosystem.”
Extending the Darwinian model, he says: “You certainly have competition but there are quite a few new species that have emerged. Not only do we have HFTs but we also have algos which are much larger.
“It’s really the battle of the bots. And we haven’t really sat down to work through the implications of these competing algorithms, but that was something that wasn’t there 30 years ago.”
Mr Cashin makes another strong case for keeping humans around, based on the 2010 “flash crash”. “[At] the worst of the flash crash we saw stocks trading at $35 and then a penny,” he says. “That never happened on the floor of the exchange because there was enough human involvement. A human looks and says that cannot be correct.”