We have spent the last two weeks dissecting the two major causes of the infamous 22% one-day drop in October 1987, and how those two causes are exponentially bigger factors in markets today.
Now, are you ready for the really bad news?
It’s about the liquidity myth, the story that says the market’s mechanical wheels are well greased.
It’s not just a myth… It’s a total lie.
Sure, there’s liquidity when markets go up, when it’s not needed. But when things go south – and they will – the myth will be revealed for what it is.
What most people believe about liquidity is a lie convened by conspiracy.
Here’s how the new portfolio insurance game and ETF arbitrage are going to unmask the frightening truth about market liquidity and seize the wheel of fortune…
Welcome to Your Nightmare
While regulators were sleeping on the job, Wall Street remade the two principal causes of 1987’s catastrophic one-day crash – remembered as Black Monday.
First, portfolio insurance, the external kind, the kind you buy to insure your portfolio won’t tank in a crash, the kind that became a hot Wall Street product in the 80’s, isn’t what the Street’s selling today.
What replaced it is something everyone’s supposed to feel more comfortable with: internal insurance.
Your portfolio’s self-insured if it automatically rebalances itself when bad stuff happens or, if you’re a passive investor, your internal insurance rider says to ride crashes out because stocks always go back up.
For big portfolio managers, the need for external insurance has been replaced by risk parity, volatility-targeting, and rules-based quantitative portfolio management game theory.
The problem is, the game they’re all playing is the same game based on volatility.
When volatility spikes and triggers wave after wave of sell orders, everyone’s going to find out they measure volatility the same way. They’re in the same positions, and they’re all rebalancing by selling the same things with spiking volatility into the same sinking market.
