How Market Crashes Happen Without More Bad News

As chief research officer for Buckingham Wealth Partners, I’ve been getting a lot of questions about the current market situation. One of the more often asked questions is, “The market is crashing some days even without more bad news; how do you explain that?” Here’s the explanation of the process that can lead to crashes like the ones we saw in October 1987, and from late 2007 through March 2009, and again over the past month or so. I’ll also explain why this time is somewhat different because there is a new set of actors on the stage, exacerbating the problem.

The process begins when bad news causes the market to fall. Given that most years see corrections (a technical term meaning a drop of at least 10%), investors are used to them. But when losses begin to exceed 10% by a significant amount, many investors reach what I call their “GMO” point. Panic sets in and their stomach screams, “Do not just sit there. Do something. Get me out!” That cohort of investors sells, pushing prices lower. That sets off another cohort that reaches their GMO point, and so on.

Contributing to the “wave of selling” are the investors who bought stocks on margin. When stocks drop by a significant percentage, those investors face margin calls and have to put up more collateral, or they are forced to sell. Many do. And that pushes prices lower, and more GMO points are hit, and selling pressure builds, even if there is no more bad news. But we are not close to being done.

When the bull market ends and we have an extended period of falling prices, investors using trend-following systems (such as momentum traders, commodity trading advisors, hedge funds and managed futures funds) not only sell their long positions, but then they switch to being short, creating more downward selling pressure on stocks. And more GMO points are hit, and more margin calls occur.

Then you have funds which manage their portfolios to target a certain level of risk at all times. While traditional portfolios are designed to target an asset allocation and let risk happen, these funds target risk and let the asset allocation react to current market conditions. Target-risk funds and risk-parity strategies calculate their portfolio exposure as a function of target volatility divided by the estimated volatility of the portfolio. During calm markets, investors look for investment opportunities in every corner of the market. There is diversity of opinion, which manifests in low correlations across different regions and asset classes. Diversified portfolios have low volatility. During such periods these funds lever up portfolios to a total exposure that allows them to maintain a higher target volatility in a low-volatility environment.

In contrast, when markets become turbulent, investors become laser focused on just one major source of risk. Correlations collapse across global regions and markets, and portfolios are revealed to be less diversified than previously estimated. Portfolio volatility estimates explode higher. Now funds need to aggressively cut exposure. They must sell into a falling market in order to maintain their target risk.