Think of last week’s stock market as a Terminator movie.
As an individual investor, you were an all-too-human Sarah Connor, up against thousands of computer-based traders (that’d be the nefarious Skynet artificial neural network). If you’ve seen the film – any of them, really – you’ll know how the showdown ended: You survived, but you got beat up pretty good.
Complicated financial instruments you’ve probably never encountered, such as total return swaps, principal protected notes and leveraged hedge funds, pounded your retirement savings. So did algorithmic trading – buying and selling that’s driven by computer programs.
It wasn’t just retail investors who felt the pain as robots helped knock down the markets on Monday and rally them massively over the next few days, only to hit them again on Friday to end the week with another sharp decline. Huge swings in stock prices, often from one hour to the next, stressed out even the most experienced investors.
“I’ve been staring at computer screens watching the stock market every day since 2003. I have not seen anything like this, ever,” says Daniel Schlaepfer, chief executive of Select Vantage Inc., a Toronto-based proprietary trading firm with more than 2,000 day traders around the world. “Never forget that when you look at how much we’re down on the day or how much we’re up, that’s not representative of how wild it is. At close on Wednesday, we were up 500 points – but at 3:40, we were up 1,300 points.”
The week’s wild ride began Sunday evening, with a series of negative headlines about rising COVID-19 infection rates and political gridlock in Washington. McDonald’s and Starbucks announced they’d only be serving customers through windows to avoid exposing their workers to the virus. The grim news triggered a sharp overnight drop in North American futures’ markets, tripping circuit breakers that halt trading for 15-minute chunks.
THIS WEEK’S MARKET SNAPSHOT
As of Friday, 10 a.m. ET
S&P 500
2,700
2,600
2,500
2,400
2,300
2,200
March 20
22
24
26
S&P/TSX COMPOSITE INDEX
13,500
13,000
12,500
12,000
11,500
11,000
March 20
22
24
26
BCE
$56
54
52
50
48
46
March 20
24
25
26
Volume (x1,000)
3,000
2,000
1,000
0
March 20
24
25
26
ROGERS
$58
54
50
46
March 20
24
25
26
Volume (x1,000)
1,000
500
0
March 20
24
25
26
HYDRO ONE
$26
24
22
20
March 20
24
25
26
Volume (x1,000)
800
400
0
March 20
24
25
26
TD
$64
60
56
52
48
March 20
24
25
26
Volume (x1,000)
6,000
4,000
2,000
0
March 20
24
25
26
FORTIS
$52
48
44
40
March 20
24
25
26
Volume (x1,000)
1,500
1,000
500
0
March 20
24
25
26
POWER CORP.
$24
22
20
18
16
March 20
24
25
26
Volume (x1,000)
2,000
1,000
0
March 20
24
25
26
THE GLOBE AND MAIL, SOURCE: REUTERS
THIS WEEK’S MARKET SNAPSHOT
As of Friday, 10 a.m. ET
S&P 500
2,700
2,600
2,500
2,400
2,300
2,200
March 20
22
24
26
S&P/TSX COMPOSITE INDEX
13,500
13,000
12,500
12,000
11,500
11,000
March 20
22
24
26
BCE
$56
54
52
50
48
46
March 20
24
25
26
Volume (x1,000)
3,000
2,000
1,000
0
March 20
24
25
26
ROGERS
$58
54
50
46
March 20
24
25
26
Volume (x1,000)
1,000
500
0
March 20
24
25
26
HYDRO ONE
$26
24
22
20
March 20
24
25
26
Volume (x1,000)
800
400
0
March 20
24
25
26
TD
$64
60
56
52
48
March 20
24
25
26
Volume (x1,000)
6,000
4,000
2,000
0
March 20
24
25
26
FORTIS
$52
48
44
40
March 20
24
25
26
Volume (x1,000)
1,500
1,000
500
0
March 20
24
25
26
POWER CORP.
$24
22
20
18
16
March 20
24
25
26
Volume (x1,000)
2,000
1,000
0
March 20
24
25
26
THE GLOBE AND MAIL, SOURCE: REUTERS
18/18
16/16
13/13
THIS WEEK’S MARKET SNAPSHOT
As of Friday, 10 a.m. ET
S&P 500
S&P/TSX COMPOSITE INDEX
2,700
13,500
2,600
13,000
2,500
12,500
2,400
12,000
2,300
11,500
2,200
11,000
March 20
22
24
26
March 20
22
24
26
BCE
ROGERS
$56
$58
54
54
52
50
50
48
46
46
March 20
24
25
26
March 20
24
25
26
Volume (x1,000)
Volume (x1,000)
3,000
1,000
2,000
500
1,000
0
0
March 20
24
25
26
March 20
24
25
26
TD
FORTIS
$52
$64
60
48
56
44
52
40
48
March 20
24
25
26
March 20
24
25
26
Volume (x1,000)
Volume (x1,000)
6,000
1,500
4,000
1,000
2,000
500
0
0
March 20
24
25
26
March 20
24
25
26
HYDRO ONE
POWER CORP.
$24
$26
22
24
20
22
18
16
20
March 20
24
25
26
March 20
24
25
26
Volume (x1,000)
Volume (x1,000)
2,000
800
1,000
400
0
0
March 20
24
25
26
March 20
24
25
26
THE GLOBE AND MAIL, SOURCE: REUTERS
When Canada’s money managers turned on their computers early Monday morning, they were greeted by a free-fall in stock prices. Shares in some of the country’s largest companies – BCE Inc., Rogers Communications Inc., Loblaw Cos. Ltd., Hydro One Ltd. and Emera Inc. – dropped 10 per cent or more. These are stocks that are expected to keep paying out dividends, in sectors that should be relatively insulated from the impact of the pandemic: telecom, groceries, electricity. Some, such as BCE and Rogers, could actually benefit from the crisis, as home-bound customers turn to streaming and other data-hungry pursuits (although just before the weekend, BCE had warned COVID-19 could have a “material impact” on its financial results – the latest signal that the market uncertainty had spread virtually everywhere).
As the trading played out over computer networks on Monday – for the first time in its history, there were no humans on the floor of the New York Stock Exchange, which shut down after two employees tested positive for COVID-19 – several forces came together to knock back stocks.
What was behind the sharp drop in prices of dividend plays like BCE? Traders working behind the scenes put it down to massive selling by U.S. fund managers that owned BCE and other Canadian stalwarts through what are known as total return swaps. These are a relatively common, tax-driven strategy that have foreign investors hire a domestic investment bank to hold a stock, then hand over or swap all future returns, including dividends, in exchange for a small fee. For the U.S. funds, the approach minimizes the amount of tax on dividends.
In recent weeks, U.S. mutual fund managers sold holdings of all descriptions, including total return swaps on Canadian companies, in part to raise cash for investors who are redeeming their holdings. Traders report that a number of hedge funds were also cashing out after taking losses in order to pay back banks that had loaned them money against their holdings (known as a margin call).
The wave of selling on Monday was followed by an equally astounding rally over the next three days. Manulife Financial Corp., for instance, jumped more than 30 per cent in two days.
Finance veterans say the level of volatility is unprecedented. “A stock like TD goes from $49 to $61 – this is the second-biggest bank in the country, and it’s flying around. That doesn’t instil confidence,” says Anthony George, head trader at Infor Financial Group. “You would expect to see a small-cap go up 15 or 20 per cent in two days. You wouldn’t expect to see BMO go up 12 per cent."
The exaggerated moves in even the bluest of blue-chip stocks are throwing various financial products out of whack. Take exchange-traded funds (ETFs), which pool money to invest in a basket of stocks based on an index, giving retail investors an easy way to diversify their holdings. As retail investors have rushed to cash in their ETFs to protect against further losses, the price of the funds have become detached from the underlying basket of stocks.
“Passive funds are just not working now – volatility is too high, prices are moving too fast," says Alfred Avanessy, head of investment banking at Cormark Securities Inc. “So what’s happening is the fund prices are not tracking the underlying stocks during the day, and this is resulting in big swings at the beginning and end of days as they try to reconcile.”
Much of the volatility stems from a lack of information. No one has ever seen entire countries go into quarantine. Nor has there ever been such a rapid deployment by governments around the world of fiscal and monetary policy tools to help stabilize banking systems and prop up the unemployed. The shifting economic landscape brought on by the virus makes trying to price companies based on future earnings a guessing game.
The volatility is being compounded by systemic changes in the marketplace – most notably, the rise of algorithmic trading. Much of the buying and selling in stock markets these days is done by computers programmed to execute various trading strategies based on movements elsewhere in the market.
Many of these models have started to break down, says Sean Debotte, chief executive of boutique investment dealer Independent Trading Group. His company uses both algorithms and human traders to conduct market-making activities for Canadian stock exchanges. Over the past few weeks, he’s had to shut off some of his algorithms; computer models designed to trade small price movements simply couldn’t comprehend the huge price swings.
“It’s like the event horizon of a black hole, where suddenly everything that made perfect sense to every quantitative model, every pairs trade, every scalp trade – it all made sense until we got to the edge of that system, and suddenly everything started to crumble,” Mr. Debotte says. “That’s the exact point where we need to stop relying entirely on these models and machines, and allow human beings to step back into the market.”
Because so much of the market is driven by computers, circuit breakers designed to pause the market, giving human traders time to take a breather amid steep price drops, aren’t working as they should, John McKenzie, interim CEO of the TMX Group, said on a conference call this week. “They were really designed historically around the ability of the market to disseminate news and to stop rampant selling. But given the level of computer trading and algorithmic trading and high-frequency trading, I think what we saw in the marketplaces is that when the markets started trading again 15 minutes later, it didn’t necessarily change any of the behaviour."
The challenge is that computer models will keep on trading based on the latest data inputs, regardless of whether there’s a pause in the action, Mr. Debotte says. “If normally we would see an average day range of $1 on a bank stock, and it suddenly moves $5, all of these systems are designed to say, ‘Well, that’s way oversold – we should buy it.’ But then it moves down $6, and all those systems go, ‘Wait a minute, this is outside our risk tolerance – we need to sell.’ "
“If we leave it all to the machines," he adds, “unfortunately they’ll continue to do the same thing – they’ll get caught in a logical ‘if statement’ loop, where they’ll continue to buy it and sell it lower, and buy it sell it lower, until ultimately it goes to zero.”
Wild price swings are also being driven by systematic changes in how markets are made. The traditional image of a market maker is a human trader assigned to a given stock. These traders hold a large amount of that stock and post prices at which they’re willing to buy and sell. Their role is to stand in the middle of the market, filling incoming buy and sell orders from their own book, providing liquidity to both sides of the trade while making money on the spread between their bid and their ask.
The market maker, however, has become something of an endangered species. Over the past decade, narrowing bid-ask spreads and higher compliance costs have made trading less profitable. Banks and independent brokerages alike have gutted their trading floors, replacing humans with algorithmic market-making tools.
“There’s not a lot of human eyeballs sitting there watching the screens doing any trading anymore, so you’re going to have these wider spreads,” says Select Vantage’s Mr. Schlaepfer.
Problems arise when almost all the liquidity in a given market is provided by computer programs that use front-running strategies, which detect incoming orders and rapidly adjust their prices, Infor’s Mr. George says. “They have their first two orders out there to get notified that there’s a buyer. Then they pull all their other orders, so you have these massive moves either to the downside or the upside."
“When the market gets solid again," Mr. George says, “then all of a sudden you have other players in the market, so it doesn’t have the same crazy swings. When somebody is confident enough to put in a big bid, he’ll stay there and buy it, and he won’t get scared because the seller shows up, and it won’t have a run down in pricing.”
So, what’s coming next week? If institutions are still listening to their computers, then fund managers will be buying stocks to stay in step with models that dictate how portfolios should balance equities, fixed income, alternative assets and cash. “Equities have underperformed other asset classes so badly in the last month that money managers are having to add to their equity allocation in order to meet minimum weights,” Scotiabank strategist Hugo Ste-Marie says. In a report Friday, he said: “Rebalancing into quarter-end could very well keep equities afloat for the next week."
Whatever comes next week, traders like Mr. Schlaepfer are bracing themselves for another rollercoaster. “Even on a good day, I have guys telling me that took a day off their life, trading this all day long."
Andrew Willis
Mark Rendell