Panic Selling In The Stock Market During The Summer Doldrums? Can't Be
It's Monday, the week of August 8th, 2011. Summer doldrums should last another 3 weeks. Trading volume in the Market should be reaching its yearly low. But wait...can't be. The Market is down 635 point. Now its Tuesday, the Market is up 430 points. Wednesday, the Market is down 520 points. Now Thursday, the Market is up 424 points. This can't be summer doldrums. So what is contributing to the Market's fluctuation like this? The answer is simple...margin calls.
What is a margin call? Investopedia defines a margin call as "A broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when an account value depresses to a value calculated by the broker's particular formula." "You would receive a margin call from a broker if one or more of the securities you had bought (with borrowed money) decreased in value past a certain point. You would be forced either to deposit more money in the account or to sell off some of your assets."
This is what happened the week of August 8th. For the last two months, the stock market has been on the decline. Since its high in May, 2011, the Market has been experiencing a slow but steady drop, from 12,800 to just before August 8th, 11,444. That's a drop of 1400 points. In an effort to find a safe haven for their assets, hedge funds and mutual funds have turned to commodities, such as gold and silver. They have bought Treasury bonds and notes, even though the yields on these instruments are reaching all time lows. The 30 year bond yield is now at 3.71% and the 10 year note, 2.25%.
The week leading up to August 8th, the Market had already seen a drop on Thursday of over 500 points, one of the highest ever selling days. So it was already a bit shaky. Then, over the weekend, the US was downgraded from its triple A rating. So Monday brought even more panic selling. When investors see the Market begin to crumble, their first thought is, sell. "I gotta get out at any price." They still remember the agony of watching their life savings go up in smoke in 2008. So even the hint of a major correction and they are ready to liquidate. Telephone calls to their brokerages on Monday abound.
For mutual funds and hedge funds who are fully vested in stocks, this is like a run on a bank. A bank operates with the view that their customers won't all come into the bank on the exact same day and demand to withdraw all their money. Believing this, banks tie up much of their money in a variety of assets, not all of which are immediately liquid. A run on a bank occurs when the bank cannot pay all its investors at the same time because it does not have enough liquid cash on hand. Customers get scared that their money is lost and demand all of their savings at once.
For brokerages, the week of August 8th was the same thing. Instead of being a run on the banks, it was a run on the brokerages. Customers all calling their brokers on the same day to liquidate their holdings and take them back to cash. If the brokerage, hedge fund, or mutual fund does not have adequate cash reserves to survive the onslaught, they are forced to liquidate their stocks, even stocks that are good dividend producing performers. The more the fund managers liquidate, the more selling occurs in the Market, the more panic occurs. Remember, they are liquidating significant number of shares, shares that other brokerages/hedge funds/individual investors are watching. Once investors see the hedge fund/mutual fund managers liquidating, they call their brokerages even faster, demanding their cash back. The fund managers must liquidate even more, resulting in even more investors calling, and even more liquidations. Suddenly a vicious cycle occurs.
It's not much different than the "flash crash of 2010" when the Market nosed dived 1000 points. But this is actually worse. While that occurred in just 1 day and the transactions were backed out, these transactions are not being recredited.
Here's the final kicker....margin calls. Many hedge funds and mutual funds buy stock on margins, money borrowed from the clearing firms to increase holdings. As long as the Market is stable, the fund managers can keep their stocks on margin with no reprisals. But as soon as the Market turns "Bearish" and starts to sell off, the Clearing Firms, the companies that actually lend the cash to the brokerages, begin to get nervous. Their immediate response is to raise the minimum margin requirements. If the fund manager cannot meet the new minimum requirements, he is forced to sell stock and raise cash. The higher the margin requirements, the more stock the fund is forced to sell, and that immediately contributes to even more panic in the Market, with more and more shares being dumped on the Market. Fund managers sell off even more stock to cover the margins, and the margins are increasing even faster. As they sell more, the Clearing firms become even more nervous and again raise margin requirements, creating even more panic selling. All in all, an amazing vicious cycle.
And remember...this panic came the week of August 8th, a week when volume should have been light, a week near the end of summer doldrums.
Barbara Cohen CIO, Shadowtraders, and professional day trader, specializes in teaching students how they can be trading futures with their own trading system and trading strategies. Ms. Cohen has helped hundreds of traders achieve their goals trading. Find out if trading futures is for you by attending one of Ms. Cohen’s Free Webinars. Check out my Futures Trading Articles. For more information, send an email to shadowsupport@shadowtraders.com or call 866-617-2037 today.