Last month in our article, Stock Prices Are a Source of Recession Risk, we discussed our view that a selloff in U.S. stocks would be the likely financial trigger for a U.S. recession in the second half of 2018. In our most recent client report, Cycle Engages, U.S. Falters, we emphasize that it is not only the absolute level of stock prices that worries us, but more importantly, the financial engineering and innovation now well imbedded in new asset classes and trading practices that could turn a simple selloff into a market meltdown.
It is worth remembering that the 2008 financial crisis emerged from declining real estate valuations and excessive leverage in a narrow sliver of the mortgage debt market known as subprime mortgages. The resulting decline in credit quality was spread like a virus through the financial system by financially-engineered products which included mortgage-backed securities as a core component (CDOs/CDS).
These instruments were not engineered to fail. Rather, the perception that their very structure actually reduced risk spurred their widespread popularity, causing the financial system to dig ever deeper into the mortgage credit markets to keep producing them.
It was only when they were subject to intense market scrutiny that investors realized they could not distinguish among the credit quality of individual instruments. As a result, the markets in which they traded failed.
As we have said repeatedly, financial instruments are “promises.” When a promise is broken, the entire system can falter because you do not know which set of promises will be broken next. The result is to heighten financial risk not just incrementally but exponentially.
In our view, the stability of the structure of the stock market itself has become much more risk prone in spite of the many regulatory changes. We view the growth in exchange-traded funds (ETFs), passive investing and high-frequency trading as a ticking time bomb that could dramatically accelerate the pace of a stock market decline should conditions warrant a selloff.
Stock ETFs (which are the majority of ETFs) differ from either mutual funds or individual stocks in that their value is not determined solely by the individual values of the component stocks. Rather they can sell at a premium or discount relative to their composite value.
ETFs operate like single assets and as such, concentrate risk in the underlying market. In the event of a sale, the ETF raises liquidity by selling individual stocks into the general market. However, the judgment that leads to the sale is not based on a single stock or commodity but a view of the market itself. Equity ETFs are now a $4 trillion market and are slated to grow almost 15 percent or about $600 billion in 2017 (Chart).
Leveraged exchange-traded notes (ETNs) take this uneasy relationship between ETFs and their underlying securities to whole new levels. Leveraged ETNs introduce their leverage by buying futures on the expectation of superior returns that may not be forthcoming.
Combining the ETF market, passive investing where algorithms activate sell programs on the basis of given trip wires, and high-frequency trading where sales (and purchases for that matter) can be transmitted through markets in fractions of seconds is, to our mind, a combustible stew. Passive funds now account for about one third of the mutual fund market, which itself is giving ground to equity ETFs.1 High-frequency trading accounts for 40 to 50 percent of all quoting activity and 20 percent of trading on major global exchanges.2
The trend in market volatility has been declining since the beginning of 2016 and has hovered near historic lows in the past six months.3 Thus, ETFs and other passive asset classes and investing/trading structures have been allowed to grow in an unusually benign environment.
Whatever one believes about stock market values, only the most optimistic would assert that there is not more downside risk than upside opportunity. The asset class structure, the speed, and the absence of the “human element” mean that there would be few brakes in the event of a selloff.
2 High-frequency trading accounts for 40 to 50 percent of quoting activity and 20 percent of trading activity on NYSE, Euronext Paris, and various European exchanges and the Tokyo Exchange. See: Bellia, Mario, et al. “Coming Early to the Party.” www.ssrn.com, Elsevier, September 20, 2017.
3 Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS].
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