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The New Crash Will Be the Same as the Old Crash… but Worse

6 | By Shah Gilani

The mechanical causes of the October 19, 1987 crash, which wiped 22% off the value of the Dow Jones Industrials Average in a day, are now a frighteningly large part of the fabric of equity markets in the U.S.

So is something else that didn’t exist in 1987.

Something that, at the exact worst moment in the trajectory of a crash, will rip the heart of liquidity out of the market without blinking an eye.

In fact, the very nature of the crash will target the people who think they are the safest.

Here’s how regulators fed the monster sleeping under passive investors’ beds…

The Myth of Portfolio Insurance

Today there isn’t just one form of “portfolio insurance,” which regulators and academics tagged as the principal accelerator of the ’87 crash.

There are thousands of equally suspect portfolio insurance strategies employed by tens of millions of investors that cover trillions of dollars’ worth of stocks.

Back in 1987, portfolio insurance amounted to shorting S&P 500 futures against long-stock portfolios. According to Paul Tudor Jones, whose hedge fund Tudor Investment Corporation made a small fortune on the ’87 crash, about $60 billion in portfolio insurance had been put in place before the crash.

There are still money managers whose trading systems are set up to short-sell index futures if markets start falling. But there are much bigger and more systemic hedging and insurance schemes in effect today.

Risk parity is a portfolio management system that, instead of incorporating outside insurance or hedging devices, aims to rebalance the mix of diversified asset-class investments within a portfolio whenever risks become lopsided. For example, if equity prices were falling, they’d be sold, and the allocation to bonds (which would presumably be rising as traders buy them in a “flight to quality”) would be increased.

Target volatility is another internal portfolio balancing strategy that sells assets whose volatility rises (increased price dispersion indicating greater risk) and reallocates capital to less volatile assets or cash.

If you think risk parity and target volatility are similar strategies, you’re right. They’re both based on volatility. The risk in risk parity is mostly measured by volatility.

Then there’s volatility itself.

The VIX, the CBOE Volatility Index that measures how volatile the market is, has become a measure of fear. When the VIX rises, it indicates the risk of a market selloff or worse.

Besides being an important stock and portfolio metric for Wall Street money managers and traders, volatility’s been embraced by Main Street.

There are several tradable volatility instruments based upon the VIX that professional and “retail” traders and investors use to hedge their portfolios, but also to speculate on the actual level of the VIX itself.

What made portfolio insurance so incendiary in 1987 is the same thing that’s going to turn all the new stock and portfolio insurance schemes into a fireball one day.

They’re all rules-based, and rules don’t care about what following them might do.

If This, Then That

When stocks start to slip, some insurance schemes will kick in. If they fall farther, more will kick in.

If they fall far enough, and no one knows where fear levels or “stop” levels are, they’ll trigger more and more rules-based selling programs, a lot of which will include index shorting programs.

In other words, the next panic will have rules-based insurance schemes, exponentially bigger now than in ’87, feeding on themselves with the same devastating effect they had on the market 30 years ago.

The market’s exposure to rules-based trading programs is huge.

The biggest hedge fund complex in the world, Bridgewater Associates, LP, which alone has over $160 billion under management, employs risk parity strategies in its giant All Weather fund and other funds.

According to HFR, a hedge fund industry tracker, rules-based quantitative strategies are used to manage $933 billion held by hedge funds.

And that’s just hedge funds. There is no way of tallying the amount of money being managed by Wall Street trading desks, bank trading desks, insurance company trading desks, institutional money management companies, and millions of retail traders and investors employing rules-based stock and market selling strategies that will automatically go into effect as conditions warrant.

It’s in the trillions.

And inherent in those trillions is the one thing that most insurance strategies have in common… Volatility.

Volatility has become so subdued, as measured by the VIX, and almost every other measure of portfolio, market, or systemic volatility, that:

  1. Risk parity funds are massively leveraged-up in equities.
  2. Target volatility funds are loaded to the gills with assets with the lowest volatility profile, stocks.
  3. Bets against the VIX rising are at record levels, meaning there are massive shorts on the VIX.
  4. Hedge funds and speculators are selling both VIX call options and VIX call option spreads for “free income” because they don’t believe the VIX will rise much.

What if it does? What if a bout of fear hits the markets? What happens to volatility then?

What happens if volatility starts rising?

All of those volatility-based insurance schemes will start kicking in.

And, as “diversified” as everyone thinks they are, the truth is they’re all “correlated” by volatility.

Of course, if you’re a “passive investor,” one of the investors in the almost $4 trillion worth of index funds sold as the safest way to invest in the market. You’re going to be all right, right?

No, you’re not.

Next week, I’ll tell you about the secondary cause of the Crash of 1987 and how its modern counterpart is going to go up like kindling.

So, stay tuned…

Sincerely,

Shah

6 Responses to The New Crash Will Be the Same as the Old Crash… but Worse

    • Glenn says:

      Volatility will go through the roof. Panic will reign. How will bit coin and block chain technology money work if the internet and electrical grid are compromised? How will it be used to buy or sell? What if simultaneously the value of our US currency is compromised and devalued? If gold and silver still have a value they could be used in trade. 30 or 40 gold 1 ounce coins would be about 30 or 40 times today’s dollar value. Spot at close to $1300. Times 30 or 40.

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