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ALERT: Re-establishing "Crash Protection"

publication date: Mar 6, 2020
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author/source: Brian Nelson, CFA
ALERT: Re-establishing "Crash Protection"
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"According to some estimates, fundamental traders, or those trading on firm-specific fundamentals, account for just 10% of trading on the exchanges today. Passive and quantitative investing, or price-agnostic trading, accounts for 6 times as much. Prices are set on the marginal trade, not on the amount of assets under management, and if most market participants aren't trading on underlying business value, this in turn, can cause widespread dislocations in prices versus reasonably estimated intrinsic values (dislocations that may never fully be reconciled even over long periods of time). In such a scenario, the capital-raising function of markets could become significantly less attractive. What CEO would want the company's stock price to be driven by quantitative algorithmic trading mechanisms and correlations with unrelated assets instead of on its company's fundamental long-term business outlook, earnings and free cash flow stream? 
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In recent decades, finance seems to have only pursued more sophisticated methods of data mining to build a seemingly endless supply of new products to sell to investors. There are now more than 70 times as many stock indexes as there are stocks, themselves, and according to research company ETFGI, there are now more than 5,000 ETFs globally, with nearly 1,800 in the US alone, and that doesn't include exchange traded notes (like the one that collapsed in February 2018). Though this sounds like a large number of diverse investing options, less than 1% of US ETFs, for example, receive more than half of fund flows. 
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What's worse, the core of what equity ETFs are made of is surprisingly shrinking. More than half of all publicly-traded companies have vanished in just the past 20 years. As speculative instruments that are based on targeting price movements in theme-based orientation proliferate (as in the case of many ETFs), the future may simply look nothing at all like the past. How could it? The decline in the number of investable stocks has reduced the variety of reasonable investable options for many savers and retirees that need better choices, not more. But fewer listed stocks and more thematic-trading vehicles isn't so bad, right? 
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Well, without enough buying and selling based on firm-specific intrinsic value calculations, or value-conscious trading, market prices may simply take on a life of their own, beyond the grasp of even the most advanced computer models that try to forecast them (perhaps the problem is exacerbated by them). That means we could experience even bigger bubbles and even bigger bursts, and they could become even more frequent. There have always been periods of panic in the stock market, of course, but for many decades now, they have always been passing, transient events. What will happen if most market participants are no longer acting on estimates of value, or on expectations of the market's estimate of value? How will prices behave then? Could there be more and more situations like Longfin, but with larger and larger companies as the ranks of passive and quantitative trading continue to swell?
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There may be just one other period in history that had more price-agnostic trading than today, and that may be the period pre-dating the publication of John Burr Williams' work The Theory of Investment Value, or roughly 1928-1940. This was the most sustainably volatile period in stock market history, as measured by daily percentage changes in the S&P 500. In the 1920s, stocks and bonds were mass marketed to the general public, and many were just speculating on the price behavior of securities they didn't understand. Back then, there may not have been much value-conscious trading activity at all. 
Today, as index investing and ETFs backed by traditional quantitative theory proliferate, market volatility may once again approach those levels, and if not checked, surpass them.
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Indexers and quantitative investors rely on value-conscious active management to set the "correct" prices. Vanguard founder Jack Bogle has said that "if everybody indexed, the only word you could use is chaos, catastrophe." The chances of everybody indexing may be zero, but what are the chances of both indexers and quantitative investing, or all price-agnostic trading, completely overwhelming fundamental value-conscious traders that calculate intrinsic value estimates, causing levels of market volatility we've never seen before? What are the chances that the arbitrage mechanism of the market in setting reasonable prices breaks down? That is a non-zero probability that can have widespread implications, impacting each and every one of our lives...
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...How should you prepare for what I believe will become one of the most volatile periods in stock market history, set off by the combination of indexing and quant trading proliferation? Within an equity portfolio, consider using enterprise valuation to estimate intrinsic value, and apply behavioral (relative) valuation to assess what others might be thinking. Think about assessing technical/momentum dynamics to evaluate the likelihood of price-to-estimated-fair value convergence, and don't dismiss the valuable information in prices, which could help you avoid value traps. The Valuentum process employs these considerations but consider diversifying your portfolio well beyond stocks, too. 
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While it is almost certain that asset-return correlations will not act the same way they did during previous crises, the concept of diversification across asset classes may save you big in the event of a systemic crisis driven by price-agnostic investors that hits the equity markets hard. There are rules of thumb about what might be the best asset allocation for your age, but only your personal financial advisor would know best for your individual situation. A good mix of Valuentum stocks (the Best Ideas Newsletter portfolio, or Dividend Growth Newsletter portfolio), high-quality corporate bonds, private real estate or businesses, certificates of deposit, and dry powder in the form of cold-hard cash could make a lot of sense for many." -  Value Trap, published December 2018
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By Brian Nelson, CFA
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The futures markets March 6 are suggesting another volatile trading session Friday after an extremely volatile past couple weeks. Importantly, the wild swings shown in the bar chart above don't tell the whole story about the extent of volatility either, as in some sessions, futures were materially negative on the trading session before the market soared and vice-versa. 
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Four out of the top 6 largest daily point losses on the Dow Jones Industrial Average have occurred during the past couple weeks, swoons of between 3%-5%. Swings in the Dow Jones Industrial Average of 400-500 points in a matter of minutes have become commonplace. While we have already, in many ways, witnessed history, (see here and here), as the markets continue to gyrate, we would expect these huge point moves to reflect ever-higher percentage changes. 
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Anecdotally, we are hearing lots more talk of algorithmic trading, and how it is becoming harder to sell any volume of equities without moving the markets. We have established a target range on the S&P 500 of 2,350-2,750 and explain how the COVID-19 crisis can catalyze into an all-out financial crisis (see here), and conditions have all the makings of another crash from here (see here). We're still only a few percentage points from all-time highs on most major indexes.
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Our prior "crash protection" worked out wonderfully, and we think adding back the protection with a portion of the "house's money," so to speak, makes sense. In our prior put-option idea, we went out to September 18, 2020 with a $250 strike. This time, we'll go to June 30, 2020, with the same strike price ($250), a 0.5%-1% weighting in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio. Please note that most options expire worthless, but such a move offers valuable portfolio protection, in our view.
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As we have announced previously, beginning April 2020, as a separate feature to our website, we'll be starting to release via email options-related ideas (two per month) and commentary, as well as educational information, to those that have subscribed to this feature. We will denote options commentary with the word 'OPTIONS' at the start of any email title for those adding this feature. If you are interested in learning more about options, please consider our new service here
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Keep your seat belts fastened, and please stay safe out there as COVID-19 continues to spread!
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Kind regards,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Please be sure to ask your financial advisor if options may be right for you. Derivatives trading is risky, can result in complete loss of premium (capital), and most options expire worthless. Valuentum's newsletter portfolios are simulated and no actual trading is taking place in them. Thank you!
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Article tickerized for holdings in the DIA.

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