Market Commentary - December 2018

As of this writing, the returns for November are nearly flat but volatility continues to be front and center. This comes after an October that was abysmal. Volatility exists for a multitude of reasons but in my opinion two reasons should be given more attention: buying on margin and short selling. To be clear, both have their purposes but the negative consequences can be severe.

One of the most volatile times in market history dates back to the stock market crash of 1929. Numerous things lead to this crash but investors buying on margin was a large one. Margin buying is basically when an investor leverages their current portfolio by borrowing additional funds from the financial institution. Margin is typically capped at 50% of the investors portfolio balance. This allows an investor to potentially increase their return as they have an increase in purchasing power without actually having the money. In return, the bank/broker will charge interest on the borrowed funds. Problems arise when investors receive margin calls due to the declining market. A margin call must be repaid to the bank/firm with cash OR by selling investments in a stated period of time. The issue stems from a bit of greed. As markets rise investors tend to become overconfident and complacent and increase their margin amounts even further. Inevitably when markets roll over, small orderly sell-offs can quickly turn into bigger ones as margin calls are triggered and investors become forced sellers. Current margin debt levels far surpasses levels experienced leading up to the financial crisis. 

A recent example would be cryptocurrencies. Twelve months ago, they seemed invincible. Many crypto investors were using margin to increase their exposure. They assumed it was a sure thing for cryptos like Bitcoin to keep doubling and tripling.In the last twelve months, however, nearly every cryptocurrency has dropped by 75% to 90%! I feel for those who invested at the height of the euphoria and some of the recent selling was attributed to margin calls and many investors were completely wiped out as this was part of the avalanche of selling we just witnessed. The same could be said for tech stocks prior to the 2000 dot-com bubble and bank stocks prior to the financial crisis in 2008. History tends to repeat itself in this way.

Short selling on the other hand, involves the sale of an asset that the seller does not actually own. Basically betting the security's price is going to go down. This strategy becomes profitable when the underlying security's price declines and unprofitable (or disastrous) when the security's price increases. Individual stocks, sectors or asset classes can come under pressure from short sellers which can lead to extreme price fluctuations that may not accurately portray the underlying fundamentals. Many wonder why stocks like Tesla and Amazon are so volatile and part of the answer lies with short sellers. They are both at the top of the list of companies with the largest short positions on a dollar basis. If enough short sellers pile on, there will be violent price swings. To a long term investor, short term price movements, while never fun, shouldn't garner too much attention as the long term outlook is most important. The SEC went as far as temporarily banning short selling during the 2008 financial crisis to "protect the integrity and quality of the securities market and strengthen investor confidence." This statement alone shows the distortion short selling can have on markets over a stated period of time.

While some of the recent volatility we have experienced maybe attributed to margin calls and short sellers, we can also point to the same two things as helping the market sustain it run up for the past several years.