The 30-year anniversary of the October 19th stock market crash occurred last month. I had started in the business in 1982, just as one of the great bull markets in history was getting underway, so I had not experienced a significant sell-off prior to that day. The 508 point (22.6%) drop for the Dow Jones Industrial Average was something no one had seen in their careers up to that point. The crash was blamed, in part, on program trading—in particular, portfolio insurance, a misnomer if ever there was one. Computer-driven programs were supposed to reduce losses through the use of futures or options, but when implemented in a falling market, they created a vicious cycle of selling. Black Monday, as the event came to be known, has been seared into the minds of nearly every investment professional who lived through it. The previous Friday had seen the market’s first-ever triple-digit point drop, as the Dow fell 108 points. Investors were therefore already preparing for a tough day over that weekend. When Monday came so did the selling, in waves which produced a total loss equivalent to more than 5,000 points in today’s market!

But are we immune from a re-occurrence of such an event? The biggest current risk, in our view, is that fact that market participants have come to rely increasingly on computers to run quantitative, rules-based systems known as algorithms to pick stocks, mitigate risk, place trades, bet on volatility, and much more—and they bear a resemblance to those blamed for Black Monday. The proliferation of computer-driven investing has created an illusion that risk can be measured and managed. But several anomalous episodes in recent years involving sudden, severe, and seemingly inexplicable price swings suggest that the next market selloff could be exacerbated by the fact that machines are at the controls. The system is more fragile than people suspect. An increasing amount of money is being devoted to rules-based investing. Quantitative strategies now account for $933 billion in hedge funds, up from $499 billion in 2007. And there’s some $3 trillion in index ETFs, which are, by definition, rules-based. The upshot is that trillions of dollars are now being invested by computers, whose trading activities are completely automated. We’ve never seen so many investment decisions driven by quantitative systems.

Perhaps the bigger question might be who would step up to buy if we saw such a downturn. Warren Buffett once quipped that investors should be fearful when others are greedy and greedy when others are fearful, but the current market structure has turned that maxim on its head. The rise of momentum and passive strategies has caused some $2 trillion to shift away from active money managers, who could be counted on to look for bargains as stocks sold off. The main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis. While not necessarily wanting to dwell on infamous times in the stock market, we recently also passed the 10th anniversary of the beginning of the global financial crisis. J.P. Morgan says the risk of another such incident remains and that the next one will be brought about by a ‘liquidity crunch’.   This reflects the risk that, following the 2008 financial crisis, central banks purchased $15 trillion of assets. Now, that accommodation is starting to reverse as central banks pull back from their actions over the past decade, like keeping interest rates near zero or making purchases in markets. This process of “central bank normalization” could lead to declines in asset prices and disruptions in market liquidity. (more…)