MorningWord 10/22/15: From Virtuous to Vicious – $SPY, $QQQ

by Dan October 22, 2015 9:29 am • Commentary

On Tuesday night, I had the pleasure of speaking on a panel hosted by Fidelity, attended by some of their high net worth brokerage clients and large investment advisers.  While the intent of the panel was to drop a little knowledge about the current state of financial markets, the conversation quickly turned hedge funds and etfs, and specifically the risks both may play in the next market correction/crash. I don’t have too many strong feelings about either, it’s been my experience living through 3 epic bull markets, 2 crashes and expecting a third at some point that there is always a bogeyman out there that is convenient for the financial press to point a finger to when it happens. Frankly whether it is ridiculously valued net stocks, cdo’s, bank leverage or a central bank induced bubble causing a crash in industrial commodities, every over exuberant market has it coming to them for one reason or the other.

My response on the hedge fund / etf front is that it is a sort of virtuous cycle in good times and vicious cycle in the bad ones.  The example I used is the current concentration in a handful of mega cap stocks among hedge fund holdings, and etfs.  Let’s look at AMZN, FB & GOOGL, which combined have about $1 trillion in market cap, and have about a 20% weight in the Nasdaq 100, which is mirrored by the etf QQQ.  The Nasdaq 100 has a $5 trillion market cap, and is up 5% on the year, or about $250 billion in gains.  The year to date combined gains of AMZN, up 80%, FB up 25% and GOOGL up 27% is about $250 billion, or about equal to the gains of the index of 100 stocks.  WOW, so these three stocks are making up for a lot of mediocre or bad performance in the majority of the stocks in the index.

So when we have periods like we did in late August, when too many people head for the door at the same time, large liquid etfs like the QQQ, or NDX futures are the first instruments hedge funds (who have concentrated positions in the best performing stocks in the entire market) use to hedge. At this point the correlation between the underlying investment, and the hedge become very high and you get the sort of sell off we had Aug 21st and 24th, hedge funds selling the QQQ, retail investors panicking and selling big winners, and massive short term volatility. The safest stocks were the hardest hit.  For instance AAPL, FB, HD & SBUX all had peak to trough one day declines of about 20% on Aug 24th, all in widely held, prior positive sentiment and performance leaders of 2015.

So will it be hedge funds, etfs, high frequency trading, the blow up of a large hedge fund holding bs roll up like Valeant (VRX) that is the spark that ignites the next correction/crash?  I suspect in hindsight one will be deemed to be ground zero, but the combination of some of their worst attributes will be the obvious cause.

So what do you do with for your own investing?  Simple, have a sense of history and respect it.  Since the Flash Crash in May of 2010 when U.S. equity markets had a sharp short term decline and subsequent recovery, it took almost 5 years to have another similar incident this past August, this time for different reasons. But it’s important to remember that sell off of May 6th, 2010 started from 1168 in the SPX, stopped at 1065, and closed the day at 1128.  WE ARE AT 2018 TODAY.

So I’ll leave you with this. Forget the popular narrative, and focus on your own risk tolerance. If the week of August 20th made you sick to your stomach after registering years of equity gains in a low volatility environment, then consider reducing equity exposure here, a few percent from the all time highs in the S&P 500.