The collapse of 2:45pm and it’s broader implications.

By subir | May 7, 2010

Like most market participants, we watched the market moves yesterday afternoon with a certain degree of amazement. Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop. But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery. It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009.

While there have been some theories put forth to explain what happened yesterday, we do not have a definitive explanation for the rapid decline and subsequent recovery. That said, we would like to share a few observations about yesterday’s trading and its broader implications:

Equity markets were already down substantially (on the order of 3-4%) before the sudden drop occurred between 2:30 and 3:00pm. During their (brief) lows, the broad indexes were down over 9% before recovering. We closed the day down 3-4% across the major indices.
The sudden decline took us through multiple significant technical support levels. Volume was steady through the morning, picked up around noon and rocketed after 2:30. Yesterday was the second highest-volume day on record.
There were various (as yet unsubstantiated) rumors of “trader error” causing the decline. There have also been reports that many high-frequency trading operators stopped trading entirely since they hit internal limits which kick in under extreme conditions.
Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets.

The last point is the most significant for investors. There is a reasonable suspicion is that yesterday’s activity in the currency markets was part of an unwinding of the carry trade. Carry-traders are very sensitive to risk since they run large, leveraged positions which can be quickly wiped out. If this is correct, the events of this week were broadly similar to moves that occurred in August 2007, which affected quantitative hedge funds mostly, and marked the beginning of the declines of 2008 and 2009. See Andrew Lo’s paper, What happened to the quants in August 2007.

The technical reasons for the stock market decline are what have received the most scrutiny in the press. In our view, the steady surrender of volume and responsibility from trading floors (where participants meet market-makers face to face) to electronic exchanges with liquidity provided by automated high-frequency trading systems certainly exacerbated the sudden acceleration of the decline, but did not cause it.

Not-withstanding purely technical reasons affecting the speed and steepness of a 15 minute decline, the underlying reasons for increased risk-aversion are real. We also believe it betrays extremely short-term memory to claim that such sudden declines do not occur in a specialist managed market. We only need to point to Black Monday (October 19, 1987), when the market dropped 22% over the course of the day. In 1987, most stock was traded via specialists on the physical floor of the NYSE. In that instance, automated selling by “portfolio insurance” providers accelerated the decline. Yesterday, the NYSE maintained a relatively orderly market, the extremely low-priced trades appear to have occurred on secondary exchanges with low liquidity where numerous market sell or stop loss orders may have encountered a limited number of bids and shallow order books. In and of itself, this is not unusual, stocks always decline suddenly when there are a lot of sellers and no buyers.

This is an interesting debate, but in our view is largely irrelevant for investors. One market commentator remarked:

For starters, let’s all keep in mind that these things don’t happen in a healthy tape. The jitters from Greek rioting and possible contagion were the necessary preconditions for a crash like that.

The major conclusions we draw from the trading action of the past week is that:

Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
The Euro-zone crisis will continue to roil markets until it is properly addressed.
There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.

Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.

An important notice