WASHINGTON, February 26, 2018: You never know what to expect from Mr. Market these days. That’s just the way Mr. Market likes it. Climbing slowly but relentlessly out of the market’s massive February tar pit of losses, Wall Street’s raging bull is attempting a serious return.* Could this be the beginning of Trump Rally #3?
After scaring the bejeebers out of nearly everyone in the investing community earlier this month, the Dow Jones Industrial Average (DJIA) is mounting a 300+ point rally as of 1 p.m. ET Monday. If it holds at least part of these gains today, the widely followed DJIA could come close to reclaiming over 50 percent of its recent volatility-driven clobbering.
The DJIA is currently up some 1.33 percent, a whopping gain if it holds. Nearly every stock in that average, save for seriously cursed General Electric (symbol: GE), is celebrating, or at least attempting to.
The other widely-followed averages, the broader-based S&P 500 and the tech-heavy NASDAQ, are up nearly as nicely. The S&P is up nearly 1 percent, while the NAZZ is lagging just a bit, gaining “only” 0.86 percent.
This is the kind of day you mourn if you sold out at the bottom. But it’s a day for rejoicing if you guzzled Maalox earlier this month and refused to panic out.
Of course a lot of the selling that gave our raging bull a walloping earlier this month appears to have been due to a massive, widespread forced error. It’s the kind of error that occurs again and again like clockwork whenever the market gets ahead of itself.
Whether it’s hedge funds, high-frequency traders, quantitative investors (quants) or individual investors – probably all of the above – stock fans have a tendency to pile into stocks in droves when market averages are on fire. The excitement is just too hard for the average raging bull to avoid.
The problem is, however, that investors, both professional and amateur, tend to overindulge in margin purchases in times like these. When some short term black swan event hits the markets, stocks first take an initial clobbering. That’s what initially happened in reaction to the ballooning January-February overindulgence in short VIX ETFs and/or ETNs. Those VIX gamblers were apparently betting on perpetual stock market calm figuring to make money on those short ETFs and/or ETNs maybe forever.
Ah yes, but let’s remember: When “everybody” climbs on board a guaranteed-to-be-fun market cruise like this one is precisely when Mr. Market teaches them all a great big lesson.
Somewhere, somehow, market volatility began to spike, slaughtering all those who invested in short VIX. In short order, they were forced to bail out, incurring big losses.
That was bad enough. But Part II of Mr. Market’s Market Mayhem Program then sprang into action. Since the early bloodletting was inflicted on the short side of the market, the initial big-loss phase of February’s violent crash caused problem #2: forced sales. Margin is, after all, the way brokerage houses extend credit. But investors, even big ones, need to maintain a certain amount of equity in each account.
If a bad bet on the short side takes an investor below that point, the investor has to sell (cash out) of other stocks in his or her portfolio. Worse, even if an investor doesn’t want to, the government’s rules and regs say your brokerage firm itself must then start dumping stocks from that investor’s portfolio until enough cash equity is raised to keep the Feds happy.
Given what happened after February Crash, Phase I, was, therefore, scarcely a surprise. As a front page article in today’s Wall Street Journal (behind a pay wall) confirms, mass quantities of selling and forced margin selling caused the second monstrous wave of the Great February Selloff.
Though this sort of thing happens time after time over the years, it seems that no one ever learns. But the real lesson here is, even a raging bull should never go hog wild in a margin accountm if you’ll forgive the mixed metaphor.
Sure, the occasional short is a good idea. We wish we’d shorted GE about 6 months ago, for example. But going crazy buying stocks, ETFs and anything else your heart desires on margin almost inevitably meets a bad end. But, while we lost a good chunk of coin earlier this month like everyone else, none of that loss was due to forced margin selling.
That enabled us to hold on to most of our positions. In turn, holding onto those stocks has enabled are portfolio to recover. Yes, we’ve regained roughly 50-60 percent of our early February losses simply by holding stocks that got way oversold. Those who sold out their portfolios in panic, or were sold out due to massive margin calls are likely stuck with their losses since they probably didn’t get back in.
Sadly, however, whenever a nasty crash happens, even professional investors are often scared to get right back into stocks. But that’s why many investors end up missing out on the first and best part of a big snapback rally like the one we’re currently experiencing.
Right. There’s nothing that says Mr. Market won’t clobber stocks again, and soon. He has a way of doing that. But it would appear the selling panic that seized Wall Street earlier this month has (mostly) run its course. Weak holders are washed out and may not return for quite some time. Things are getting chance to stabilize.
Better yet, once the see-saw market gyrations settle a bit further, markets may remain more rational in the months to come, leading to calmer volatility and a calmer VIX.
We confess we are at times a bit like a classic raging bull in our columns. Since January 2017, investing has been fun again, particularly after enduring 8 years of a socialistic, business-hostile administration in Washington. Even so, since we started investing back in the 1980s, we rarely invest in anything on margin. A good run in stocks will inevitably lead to a bad one, and if you’re too margined up, you’re likely to get hosed. But if your portfolio isn’t in margin hock, your broker can’t dump chunks of your portfolio when you experience a nasty market temblor. That’s still up to you. Control. We like that here.
That’s why most investors should be very, very cautious when they try to use leverage to pump up their returns. What often happens in the end is precisely the opposite effect.
*NOTE: WSJ link may currently reside behind a paywall.