Making Sense of the Recent Market Volatility

Over the past several weeks, the investment markets have experienced significant volatility. July and August, which are usually calm months, have instead been quite turbulent. Uncertainty surrounding the subprime mortgage market has resulted in a severe reduction in available liquidity, causing investment managers to sell securities ‒ often their highest quality holdings ‒ to raise cash. As a result, the prices of high-quality stocks have fallen more than those of lower-quality stocks. Quantitative investment managers have been hit especially hard.

The Subprime Impact

During the past few years, rising residential real estate prices made it difficult for some buyers to afford a new home. A traditional 30-year mortgage, requiring a 10-20% initial down payment, became unaffordable. To make it easier for prospective buyers with low credit ratings or with limited funds to buy a home, mortgage lenders began to offer more flexible mortgage options. These included a 2/28 mortgage, which allows a buyer to pay only interest on the loan for the first two years ‒ usually at an artificially low interest rate. After that time, the rate would be reset at current market rates, and principal and interest would be paid for the remaining 28 years of the loan.

Fast forward to today. The residential real estate market has turned downward, interest rates have risen, and many subprime loans are being reset. Not only are mortgage interest rates increasing, but mortgage payments in many cases will also begin to include repayment of principal plus interest. This will result in substantial increases in monthly mortgage payments. Because of the downturn in real estate values, many homeowners now have “negative” equity in their homes ‒their mortgage loan is worth more than the value of their house. As a result, it’s likely that many of these loans will default.

So how does this affect the investment world? In a process called securitization, these subprime mortgage loans, and others like them, were packaged and sold to the investment market as collateralized mortgage obligations (CMO’s) or asset-backed securities (ABS). Fixed income managers regarded these securities as relatively safe investments, as the mortgage payments would provide the return on investment. These CMO’s and ABS’s were also a favorite of hedge fund managers.

Liquidity Crunch

The uncertainty created by the expected increase in default rates of these subprime loans has created angst among investors, and has led to market volatility, as investors look to withdraw their assets. This liquidity “crunch” has extended into the equity markets, as hedge fund managers and others who have been using leveraging strategies have seen their source of cash dry up, causing them to sell some of their equity holdings. With leveraging, the goal is to earn an additional return by investing profitably with borrowed money. But if the investment loses money, the manager must make up for the shortfall by selling additional assets. This is what has been happening to certain hedge funds.

As the value of individual stocks fall, lenders look to borrowers for additional loan collateral. Investment managers generally use the cash on hand to meet these “margin calls.” Unfortunately, in today’s market, cash on hand has been scarce because of some substantial hedge fund redemption requests. Additionally, the subprime liquidity crunch has caused additional lines of credit to dry up. Faced with the need to raise cash to meet redemptions, as well as to meet margin calls, hedge fund managers began to sell high-quality stocks, which can be sold quickly, and provide needed cash. Along with meeting the redemption requests, the cash was used to repurchase shares of lower quality stocks that the managers had “borrowed.”

The Quantitative Perfect Storm

As high-quality stocks flooded the market, the supply and demand imbalance resulted in significant price drops for these stocks. As prices fell, investors became nervous, leading to more selling. In this environment, investment managers following a quantitative strategy experienced the most difficulty. That’s because quantitative strategies rely on multi-factor computer models to determine which stocks to buy or sell. The factors are based on historical market data. Generally, quantitative strategies overweight or underweight certain stocks in relation to their benchmark indices. Trading for these portfolios is also driven by computer models, which recognize market movements as opportunities.

But the models are only as good as their inputs. The “perfect storm” arrived as hedge fund managers sold high-quality stocks to buy back their lower quality stocks. The selling was exacerbated because several hedge fund managers followed similar quantitative strategies. Selling led to more selling, which led to continual decreases in high-quality stock prices.

Quantitative investment managers outside of the hedge fund world saw their holdings greatly depreciate in value as a result. While the fundamental characteristics of the individual securities had not changed, the pressures created from the hedge fund sell-offs were generally well outside the normal parameters of their models.

What Does This All Mean?

While the subprime situation has leaked into the broad based equities market, it is important to remember that for the most part, the fundamentals of these companies are still sound. Even strong companies with strong fundamentals and increasing earnings are taking a hit, but as things begin to equalize their value will surface again. If your investing horizon is geared toward 20 years or more, this market activity should have little effect on your holdings provided your asset allocation is appropriate.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

5 comments
Asset Manager
Asset Manager

Enjoyed the article. One interesting situation that we looked at when covering the issue was a report by Trimtabs. One of their directors was quoted as saying redemptions in June and July from hedge funds "likely sparked the dislocation in the equity markets in the summer".

In a bizzarre twist, it looks likely that nervous investors withdrawing money from funds actually contributed to the market decline. A self fulfilling prophecy if evr I have seen one..

Jeremy
Jeremy

David, I would guess that additional news on foreclosure numbers will continue to have an impact over the short-term, but in the end, what the Fed does with interest rates will have an equally important role.

I think it is funny how right now, strong economic data can actually hurt the market because it reduces the chance that the Fed will cut rates. You would think that strong economic data would be good, but that isn't where the focus is, so everyone is hoping for a rate cut.

That being said, I would expect the volatility to continue as various pieces of data come out, including foreclosure rates, but you'll see swings the other way as the Fed reacts. I think this will just continue to keep the market choppy as things like rate cuts, bailouts, or other measures are more or less just short-term band-aids on a much larger issue.

David
David

Excellent analysis. Do you think an increase in foreclosures will bring the market further down in the short term? Or will action by the Fed be enough to counter that?