March 7, 2021

High & Low Finance: Who Is to Blame if Shares Continue Steep Declines?

William Shakespeare,

Macbeth, Act V, Scene 5

At the end of last week’s wild stock market gyrations, share prices were down only a moderate amount for the week, leaving investors to wonder whether there was any meaning at all to the volatility.

As is often the case when market gyrations become excessive, governments have good reasons to hope that the significance, if any, lies in market imperfections rather than in fundamental economic problems.

If it is the latter, attention is likely to be focused on issues of sovereign debt in Europe and on whether governments on both sides of the Atlantic have the ability and the will to prevent a new global credit crisis and recession.

If it is the former, then it is the behavior of market participants, or problems of market structure, that is to blame. In the past, that explanation has been much more palatable to politicians. Sometimes it has even been correct.

If it is not real economic problems that are responsible for sharp falls in stock prices, then the blame is likely to fall, as it has in the past, on people who seek to profit from declines and on market innovations, such as stock index futures and computerized trading strategies.

Short-sellers, who bet that prices will go down and thus perhaps help to push them down, are almost always among the first targets of political criticism, and this year is no exception. At the end of last week four European countries banned short-selling of financial stocks, and Germany renewed its push to get Europe to prohibit what it calls “naked short-selling” of credit-default swaps.

It is particularly angry about swaps that allow people to place bets that governments will default on their debts. Germany’s proposal would mean no one could obtain such protection against, say, an Italian default unless he owned Italian government bonds and needed protection.

Until 2008, Wall Street almost always opposed restrictions on short-selling. But that year investment banks became strong supporters of banning such sales and investigating people spreading negative rumors.

It was not, of course, a coincidence that the rumors then were about banks. After Lehman Brothers collapsed, short-selling of financial stocks was banned. It bolstered stock prices for a while, but did nothing to halt the rot that really was spreading within bank balance sheets.

So far this year, the United States has not joined in taking action against short-selling, although regulations on it have been strengthened since the 2008 plunge.

In the 1920s, the targets of scorn were Wall Street pools, thought to be pockets of capital that would manipulate a stock up and then profit by dumping overpriced shares on speculators lured into thinking the rising price was a result of more than manipulation. After the 1929 crash, the pools were widely blamed for bear raids, which were more or less the opposite and used short-selling to drive down prices. Attacking the speculators did not, in the end, do much to help the prices.

In the 1987 crash, portfolio trading, made possible by the relatively new stock index futures market, became a target of criticism. That strategy involved taking offsetting positions in the futures market and the stock market, such as by buying a futures contract and selling short the underlying stocks

Traditional money managers loved being able to sell a futures contract quickly to protect against losses in a declining market, but were outraged that the buyer of the contract immediately sold shares short, seemingly without regard to price.

Related to that was a product called “portfolio insurance,” which convinced money managers they could buy stocks without much regard to price, secure in the knowledge they could use futures — or options on futures — to exit quickly in a down market.

Since the sale of futures by portfolio insurers was based on a computer program that assumed continuous markets, it had no way to stop selling when prices became ridiculously low. Humans who understood what was happening had no desire to buy until they were sure the portfolio insurance traders were through.

The Dow Jones industrial average fell 22 percent on one day, on Oct. 19, 1987.

In a way, the flash crash of May 6, 2010, was similar. It brought high-frequency trading firms to the fore. As markets became more and more electronic, and computers enabled trades to be completed in milliseconds, those firms had come to supply most of the liquidity needed to allow markets to function.

That is, when normal investors wanted to buy or sell stocks, the high-frequency firms were often on the other side of the trade, making small amounts on many trades. They had taken over a profitable function once restricted to stock exchange specialists and Nasdaq market makers, which were required to post bid and asked prices and to step in to buy when others did not wish to do so.

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