When markets fall, they sometimes pick up downward momentum because of the financial market equivalent of a snowball rolling downhill. The “forced sale” of stocks and bonds are partly to blame for the collapse in stock markets yesterday. The most important thing? Be sure you’re not caught in that snowball.
A forced sale – which is sometimes the result of a what’s called a margin call – happens when an investor needs to sell an asset immediately (no matter the price) in order to raise cash to meet a financial obligation. In normal market conditions, an investor sell only when he wants to, and decides when he’ll get the best price. But if he can’t wait and must sell at once, he’s at the mercy of the buyer – and in the middle of a collapse in markets, buyers can be very choosy.
For example, imagine you buy a rental property and use the rental income to cover the mortgage. But then the local economy sours, and the real estate and rental markets weaken. Your tenant leaves for a job elsewhere, and now you have no rental income to cover the mortgage. When the next mortgage payment is due, you scramble to find the cash, and wind up having to sell your car. You get a bad price for it, as you had to sell in a hurry, but you’re able to make the payment on your rental property.
But a few months later, you still don’t have a tenant. And the cash you raised from selling your car has run out. Your only choice is to sell the rental property. But other people, who similarly were relying on rental income to cover their mortgages, also lost their tenants – so a lot of properties are up for sale. As there aren’t many buyers, you have to cut the asking price sharply. As a result, the proceeds aren’t enough to cover the outstanding loan – so you also have to sell your motorcycle in a hurry, at a fire-sale price. That’s another forced sale, and another loss.
This is similar to what’s been happening in financial markets. Many investors, both individuals and at hedge and mutual funds, borrow capital to buy securities “on margin”. That means they are lent funds by banks and brokers to extend their buying power (similar to a mortgage).
When the value of the investor’s holdings drops (for example, in a general market decline), the broker demands that more cash be deposited to cover a certain percentage of the amount borrowed. If the investor doesn’t have the cash, some of the securities in the account held by the broker are sold – regardless of the price or market conditions (like selling your property if you can’t make the mortgage payments).
If this happens on a large scale – lots of margin calls on lots of big investors at lots of banks – the forced selling can create a negative spiral (like selling your rental property in a bad market). It’s even worse when investors have borrowed enormous sums relative to their underlying assets (which is like taking out a mortgage with a very small down payment). When this happens, a negative spiral pushes markets down further.
In markets now, the decline in the price of oil is also creating forced sellers. Sovereign wealth funds (big, state-owned investment funds) in some oil-producing countries, such as Saudi Arabia, are likely being forced to sell some of their holdings. They’re not getting margin calls, but the government – facing lower revenues because of the lower oil price – needs to fill budget gaps, and is looking to the sovereign wealth funds to help. So they have to sell holdings, in a hurry, in the middle of a market downturn.
During corrections in markets, forced selling can get ugly. And because forced selling is self-reinforcing – forced sales trigger more forced sales as markets decline – there will probably be more in coming days.
How can you avoid being caught in the snowball of forced selling? Ensure that your portfolio is sufficiently diversified, with uncorrelated assets. If you buy on margin (which some more aggressive investors might do), be sure you have enough cash on hand to meet a margin call — before you get one. Or, better, watch your stop loss levels to ensure that you don’t reach that stage in the first place.