by David Reavill
On Monday, the markets experienced a “Flash Crash.” You may have missed it because it was over almost before it began. An alleged photo on Twitter triggered this tiny crash that a fire was burning near the Pentagon in Washington, DC. But before our little dip could gain momentum, the local Fire Department declared that there was no fire, and several sharp-eyed Twitter commentators noticed that the “photo” was created by AI (Artificial Intelligence).
From start to finish, the entire event took about 15 minutes. But in that short time, an estimated half trillion dollars in market cap had been lost as traders slammed their sell buttons hard. Then Wall Street saw that the whole thing was a hoax, and the tiny “crash” was over.
Unfortunately, since then, most of the discussion has centered on the relative merits of the AI that created the photo and whether or not it was a credible deception. While that may be an excellent discussion for my friends in the tech sector, it misses a much larger story for those of us in finance. For us, the who and why of this story gives a fascinating insight into just how fragile the current bull market is.
So, the selling funds were likely large Mutual Funds, Exchange Traded Funds (ETFs), and Index Funds. We are most familiar with all those funds and may be invested in them. We likely have these Retail Funds in our IRA, 401(K), or other long-range retirement accounts. Most of these funds are passively managed and rely on a “benchmark” to guide their investment strategy. The most popular of these kinds of funds rely on the S&P 500 Index as their guide. These funds try to match the performance of the top 500 stocks and benefit from the long-term appreciation of the Stock Market.
The legendary investment manager John Bogel, the founder of the Vanguard Funds, invented these funds. Following the benchmark, Bogel’s investing style has come to dominate how most of us invest. It has provided market average returns by utilizing meager expenses and passing most of the returns on to investors. This strategy has worked well and enabled Investment Managers to handle the vast sums they manage today.
Hat tip to Mr. Bogel!
However, we may be coming to a time when this kind of investment management reaches a blip, that one in thousand times when passive investing runs into trouble. And that’s what happened on Monday.
The most challenging time for any Fund is when many of your fund investors decide to sell. In the industry, we call these times “net redemption.” It’s when the sellers outpace the fund buyers. It most often occurs during bear markets, where investors are exiting stocks. Interestingly, the most prolonged sustained period of net redemptions was in the 1970s, before Bogel’s model of benchmark investing had gained market share.
In the old fund investment models, where a fund manager actively guided the fund, they could anticipate fund redemptions and build up their cash reserves by selling positions early. Then, when the redemptions hit, they already had the cash to meet them. But by investment policy and often prospectus, there are other options that the new benchmark funds have. They must remain fully invested at all times, matching the benchmark. For them, redemptions become a reactive condition, where fund sales begin, and simultaneously fund managers must also sell to meet those redemptions. And that’s likely what happened Monday. Benchmark Fund Managers saw a wave of redemptions headed their way and were selling to meet what was coming.
What led the Funds to believe that redemptions might be in their future? Answer the comments of outspoken St Louis Fed President James Bullard earlier Monday morning. Those comments demolished Wall Street’s predominant view of the Federal Reserve’s actions on interest rates this year. Wall Street thought the last interest rate hike just three weeks ago would be it. In Wall Street parlance, that hike was terminal. And we could start putting interest rates behind us. High-interest rates are always an impediment to investors, as the high rates slow the economy and make other interest-rate investments more attractive.
But Bullard utterly destroyed the notion that the Fed was through raising interest rates. He stated that interest rates would need to go higher this year, likely by 50 basis points. And:
“If inflation is not controlled, the Fed will have to do a lot more, should err on the side of doing more.”
Not only was the last hike not the last, but Bullard is saying that we could see interest rates that are much, much higher.
It came as a total shock to the Street. All our assumptions about the direction of interest rates and the monetary tightening of the Federal Reserve would have to be revised. Bullard had clarified that this Fed was likely much more Hawkish than most of us thought possible.
From Ballard’s point of view, the chances of a Recession are meager, as exhibited by a strong labor market. Many analysts, myself included, could not disagree more. From our perspective, a Recession lurks close by, with many calling for Recession sometime next year. But Bullard made clear that the Fed does not see a Recession anytime soon and thus feels free to continue raising interest rates.
And as Wall Street was mulling over those words from James Bullard, came the word that the Pentagon was on fire. What would you do? If you’re a benchmark fund manager, you’d probably hit the sell button. And on Monday, that’s just what many did.
Dig Deep and you find that someone was behind this and made Billions. This is why all trades on the Market should have a 24 hour cooling off period; request a trade and it can’t executed for 24 hours, but it can be cancelled at anytime in advance of the actual trade. This would bring incredible stability to the Markets, but that is not what money manipulators want.