Another Crisis Comes and Goes

Another crisis comes and goes almost before you can understand it.

Monday, markets in Asia took a beating as the Italian constitutional referendum result became clear.

Then, European markets opened. What would happen? All eyes were on the FTSE MIB index. The reaction?

Italian stocks fell 1.71% on open. Crisis ensued.

But wait, don’t panic. Within an hour, the Italian market was up 1.59% on the previous day’s close. What crisis?

By the end of the day, the FTSE MIB index was down just 0.21%.

What’s the deal? Are crises now just water off the market’s back?

It looks that way. We’ll explain what that means below…

Still waiting for the next crash

From 2011 through to the end of 2014, I told investors to ignore the swathe of crises that were hitting the market.

I said that all the crises that were hitting the front pages of newspapers and making headlines on the nightly news weren’t really crises at all. They were fake crises.

We have a simple reason for that view.

After missing the biggest crash in 70 years, mainstream and even many contrarian commentators were on the lookout for the next one.

They didn’t pick the collapse of the US housing market, the collapse of the banking system, or the collapse of stock markets. So they were determined to pick the next collapse.

But what would it be?

Would it be the rise in Chinese interbank rates? No.

Would it be the Cyprus bank bail-in? No.

Would it be Russia’s annexation of Crimea? No.

Would it be revolution in North Africa or the Middle East? No.

Would it be the US debt ceiling? No.

Would it be the European debt crisis? No.

Would it be any of the other 30-plus crises handpicked by the hapless saps in the mainstream media (and some of the wannabe heroes in the alternative media)?

Short answer: No.

Here’s the problem: When everyone is looking for a crisis, the crisis tends to…well…not happen.

The potential for a crisis means that investors take fewer risks, or they take out ‘insurance’ against the outcome of such a crisis.

That’s one reason you saw a big rebound in US and European markets following the US election and the Italian referendum.

Anticipating the potential of a Donald Trump win, investors short sold stocks, sold futures contracts, or bought put options.

So, when Trump won and Italians voted down Matteo Renzi’s referendum, the short sellers bounded into the market to cover their positions.

The net effect was that the short covers, along with those looking for a bargain, helped push stock prices back up again.

Does that mean you shouldn’t worry about a crash, or at least worry about trying to predict one?

No, it doesn’t mean that at all. But we do believe that investors shouldn’t become obsessive about trying to pick the exact crisis, which will cause the precise crash, on a specific day.

Instead, investors need to be aware of, and plan for, the next crisis, without allowing it to get in the way of making sound investment decisions.

The following chart will help explain our point:

Source: Bloomberg
Click to enlarge

What do you notice most? That’s right, over the long term, stocks have gone up. That’s why we figure it’s wrong to obsess about crashing stocks.

But that doesn’t mean you should ignore the potential of a crash. Because what else do you notice? That’s right; after periods in which the market rises, the market experiences a massive crash.

But look at the infrequency of major crashes. If you listened to the mainstream media, and their attempts to predict a crash, you’d think markets fell off their perch every day of the week.

An unsafe ‘safe’ investment

After all that, what do you think we’re going to do now? We’re going to warn you about a major systemic risk that could put the market in extreme peril.

To be fair, what we’re about to show you isn’t necessarily a catalyst for a crash. But it is something that could exacerbate the problems when the crash hits.

We refer to this clipping from the Financial Times:

Stock markets have a new purpose. Once devoted to trading stocks and setting their prices, they are now the venue for buying and selling something other than shares: exchange traded funds.

ETFs are taking over markets. Shares in Apple, the world’s biggest and most heavily traded company, turn over more than $3bn each day. But that is dwarfed by the biggest ETF, State Street’s SPDR S&P 500, which trades more than $14bn each day. Five of the world’s seven most heavily traded equity securities are ETFs…

It is not just in trading that ETFs dominate. Their assets under management were negligible 20 years ago, but now exceed $3tn. They hog flows of new money and are revolutionising the business of long-term saving, once led by traditional mutual fund groups. Over the past 12 months, according to the research firm Morningstar, $130.7bn has flowed out of all US mutual funds, while $240bn has flowed into US ETFs.

The influence of ETFs isn’t new. They’ve grown in importance and popularity in recent years.

According to Bloomberg, US$1.08 trillion has flowed into ETFs over the past three years. US$319.25 billion has flowed into ETFs so far this year, on pace to eclipse last year’s US$368.43 billion inflow.

The biggest ETF, the S&P 500 ETF mentioned by the FT, holds US$208.48 billion in assets. If that ETF was listed on the Aussie market, it would be the ASX’s biggest stock by market capitalisation, beating Commonwealth Bank of Australia’s [ASX:CBA] $135.16 billion market cap.

So, what’s the risk here?

The risk is in safety. Or rather, the perception of safety.

Individuals and fund managers buy ETFs because they figure it’s an easy, low-cost transaction. Instead of buying a whole bunch of individual stocks, they just buy an all-in-one ETF instead.

If it goes up, they get the market return. If it goes down, they get the market return. Easy.

The problem is that, aside from the investment ease of ETFs, investors buy them because they perceive ETFs to be safer than buying individual stocks.

That perception of safety has a number of consequences, the most important of which is complacency. Believing that an investment is ‘safe’ can cause an investor to invest more in a stock than they otherwise would.

After all, doesn’t every investor learn that diversification is important? That, in order to lower your risk, you should buy a bunch of stocks? In that case, what could be safer than an ETF, which invests in all the stocks comprising the S&P 500?

To answer that, we need look no further than a chart of the S&P 500 ETF:

Source: Bloomberg
Click to enlarge

From 2000 to 2002, the ETF lost 45.61%.

It took nearly eight years to regain the high, before promptly falling again. This time by 47.88%.

It then took another six years to regain that high.

Over the long term, stocks do have a history of rising. That said, an investor who bought the ETF near the top in 2000 didn’t see any real capital growth on their investment for another 13 years.

And even if you argue that the ETF has more than doubled since 2008, the annualised return since 2000 is only a paltry 2.33%.

And the annualised return since 2009 is still only 14.22%. That’s pretty good. But is it enough to stop investors selling in a panic when the next crisis truly hits?

We doubt it.

Therein lies the systemic risk of ETFs. Investors buy ETFs for safety. But ETFs aren’t safe. The correlation between the S&P 500 and the major ETFs that track it is near perfect.

When the market goes up, the ETFs go up. And when the market falls by half, the ETFs fall by half, too.

We’re not saying that ETFs will cause the next crash. That doesn’t seem likely, unless you’re talking about some of the leveraged ETFs. But we are saying that ETFs, given their size, could contribute to exacerbating the crash, as investors who had looked for safety suddenly realise that ETFs, being a stock investment, aren’t safe at all.


Kris Sayce,
Publisher, Money Morning

Editor’s note: The above article is an edited extract from Port Phillip Insider.

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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