What I found most interesting about Nicole’s reminiscences was just how fragile the system became when confidence dried up that weekend. We often talk of the importance of including uncorrelated assets in balanced portfolios, and it is certainly true that correlations have weakened as the bull market has lengthened. But, as Nicole recounts, even assets seemingly unrelated to equities came under heavy selling pressure as traders sought to cover losses, while failsafe ‘circuit breakers’ meant to stabilise the system exacerbated the problem – price discovery, she remembers, became impossible.
This, I think, is a much more useful lesson to remember than plentiful attempts to work out whether we should expect another Black Monday right now – that there might not be too many safe places when the significant correction that many are predicting finally does come. The other is that, despite the thousands of column inches devoted to predicting it – including our own analysis in August that revealed several indicators flashing red – that correction will still feel as though it has come out of the blue, especially to the indiscriminate buyers of equities that may have contributed to the market’s recent spike. Keen to catch the upward trend, retail buyers, especially in the US, have been piling into index ETFs, and borrowed to do so, and critics suggest that this buying pressure has driven markets higher still, with scant regard for valuations – another failure, some say, of price discovery.
These charges have been dismissed by the industry, not least the largest ETF provider, BlackRock, which published a paper this week attempting to blunt the critics’ arguments, but many remain wary. Whatever the case, it’s good that this debate is now happening. I was never entirely convinced of the argument that ‘passive = good, active = bad’ – there are plenty of examples of both in each camp. And even if the rise of passives is, in fact, benign from a market perspective, it pays no harm to check that the industry’s defence stands up to scrutiny. By happy coincidence, this week we have also looked at the conditions that led to the credit crunch of 2008 in the returning 50 Objects series and, as Philip Ryland observes, many seemingly innocuous and unrelated developments over a long period eventually combined to cause the biggest financial catastrophe since 1929. What the tipping point will be for the next crash we don’t know. But it is a certainty that similar complacency will be lurking somewhere.
