“Hit the bid!” is the time-honored instruction screamed when markets are crashing. “What bid?” is invariably the response. Way back in 1987, portfolio managers thought they would be protected from a market crash with “portfolio insurance,” which would employ “dynamic hedging” strategies to buy or sell hedging instruments when a market crash got going in earnest. The strategy failed miserably as the market crashed on October 19, because there was nobody to take the other side of the insurance trade. The hallmark of market crashes is that everybody is trying to get out at the same time. From Wolf Richter, at wolf street.com:
They were just about all there at the Las Vegas SkyBridge Alternatives Conference, or SALT: Daniel Loeb, T. Boone Pickens, and of course George Papandreou, who in March 2011 as Greek prime minister had produced one of the funniest official Eurozone lies ever when he reassured those that were being shanghaied into bailing out Greece: “We will pay back every penny.”
A couple of thousand others were there, including John Paulson, who made billions after betting against bonds backed by subprime mortgages using credit default swaps. “Hedge fund stars,” the New York Times called them. One of these “stars” was Ben Bernanke who, in his function as Fed Chairman, has done more for these hedge funds stars than anyone else, ever, period.
They all have one thing in common: They’re going to ride this Fed-gravy-train all the way to the end. They’re going to max out this rally in stocks and bonds and real estate and what not, though the oil-price crash has knocked a serious dent into their shiny veneer. And they’re going to add to their gains to the very last minute, fully leveraged, fully aware that this won’t last, totally cognizant that this is artificial and that its end is drawing closer. Then, at the first rate increase or whatever other sign they might see that the gravy train starts derailing, they’ll jump off.
That’s the plan. In this overleveraged market, their twitchy fingers are going to hit the sell button all at once, assuming that there will still be buyers out there, that there will be enough liquidity in the markets to where they can get out without having to pay an extraordinary price, and before everyone else is trying to get out.
But market liquidity, when you need it the most, just evaporates. It’s “one of the most under-appreciated risk factors facing most investors today,” Mohamed El-Erian, chief economic advisor at Allianz, told Business Insider. He went on:
Aided and abetted by ultra-loose central bank policies, investors have collectively embraced a liquidity illusion – or, to be more precise, stumbled into a liquidity delusion.
As a group, they believe that, should conditions cause them to change their collective mind, there will be enough liquidity in markets to reposition their portfolios with relative ease and at a relatively low cost. But this belief runs counter to both structural conditions on the ground and recent market signals.
Part of this “delusion” of liquidity is due to the “pronounced decline in the risk absorption appetite of broker-dealers,” he said.
To continue reading: How the Liquidity “Delusion” Leads to a Crash
After the Oct 1987 20% decline, I framed a copy of the WSJ Dow for that October and put the below quote on the same page. Still have it.
“October: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February.”
– Mark Twain
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