It was almost inevitable something bad would happen. Barely a ripple had disturbed the smooth surface of financial markets since May last year. But on February 27th share prices were suddenly hit by a wave of selling.
It is always possible to find plausible reasons for a sudden stockmarket fall after the event — less easy to pick them beforehand. The immediate catalyst for this week’s troubles appeared to be a near-9 percent fall in the Chinese stockmarket, itself triggered by stories that the authorities were about to clamp down on speculation. But the truth is that investors were simply looking for excuses to take profits.
A decline looked overdue. Wall Street had enjoyed its longest period without a 2 percent daily fall for more than five decades. Margin debt — the money sharebuyers borrow from brokers — had just passed its previous peak, recorded during the dotcom bubble. Risky assets, from high-yield corporate bonds to emerging-market debt, were offering historically low yields.
When it came, the sell-off was dramatic. At around 3pm New York time on February 27th, the Dow Jones Industrial Average was down by a couple of hundred points. In less than a minute, it plummeted another 200 points — a rate of decline that traders said was unprecedented.
The speed of the fall was caused by a tabulation delay. The data-systems arm of Dow Jones, which calculates the average, had been unable to process orders quickly enough as they surged during the afternoon. At 3pm the firm switched to a back-up system in an effort to unblock the pipe. This did the trick, but caused a massive instantaneous fall in the average as it readjusted after the delay.
This was not the only problem. Floor traders were unable to keep track of computer-driven orders, particularly those selling exchange-traded funds — baskets of stocks linked to an index. At its low, the Dow was down 546 points, among the worst points falls in its history.
None of this was good news for John Thain, the NYSE’s chief executive. He was seen on the trading floor just after the 3pm meltdown, looking flustered and spurning interview requests. With competition between traditional exchanges and electronic networks hotter than ever, the last thing he needs is questions over the robustness of the NYSE’s technology.
Inevitably, Wall Street set the tone for the rest of the world, with European, Asian and emerging markets falling heavily in its wake. But on February 28th the American market showed signs of stabilising.
Will that be it? Certainly those investors interested in the “fundamentals” can find things to worry about. Tensions over Iran’s nuclear programme are still high, and the oil price is $10 a barrel above its recent lows. The recent defaults in the subprime mortgage market may be affecting other bond investors and cutting off credit to the housing market. Some recent American economic data have been weak and Alan Greenspan, the former chairman of the Federal Reserve, has mused publicly about the possibility of a recession.
His successor, Ben Bernanke, did his best to allay fears of an immoderate slowdown. If he is wrong, he can always start lowering interest rates. The “flight to safety” has already caused Treasury bond yields to fall, cutting the borrowing costs of homebuyers.
But it may be the internal dynamics of the markets, not the evolution of the wider economy, that decides whether this is a brief shakeout or the start of a serious correction. Periods of low volatility tend to encourage risk-taking. Hedge funds have a natural inclination to buy higher-yielding (and thus riskier) instruments and sell low-yielding assets, since this delivers a positive income or “carry”. When the market falters, these positions rapidly lose money. For example, the modest rise in the yen — 2.3 percent against the dollar on February 27th — wiped out about half the annual interest gain accruing to investors who sold yen and bought dollars. Those who gambled on the “carry trade” may decide to cut their losses.
As they do so, other investors may hurry to shift their feet. Investment banks use “value-at-risk” models which mean that, when volatility rises, they cut the capital they allocate to trading. This usually means selling assets. So a sudden jump in volatility tends to generate further volatility. “The sell-off was merely a warning shot,” says Chris Watling of Longview Economics, a strategist who recently forecast a correction. “Investors should expect further selling in coming weeks.”
What matters is how many actors have all made the same bet. One of the oldest market mistakes is the assumption that you can get out of a position as easily as you entered into it. According to Goldman Sachs, the latest jump in the Vix (a measure of stockmarket volatility) took it eight standard deviations from its average. If conventional models are correct, such an event should not have happened in the history of the known universe. Then again, the move in energy prices that caused the collapse last year of Amaranth, the hedge fund, was a nine standard-deviation event. Perhaps modellers do not know the universe as well as they would like to think.
This is what makes markets prone to nasty surprises and it explains why investing with borrowed money can be dangerous. If some bank or big hedge fund has been caught out by the sudden sell-off, the events of February 27th could have lasting implications. The stockmarket has seen blacker Tuesdays. But this one may cast a long shadow.