(By Anthony Harrington via
QFinance) It is not unusual for investors to find the markets moving in ways that
seem to defy common sense. Companies often feel the same way. They
announce good results, they have a great product pipeline and plenty of
cash in the bank and the stock price falls off a cliff. The directors
throw up their hands and wonder what on earth the markets expect from
them.
Some lose patience and initiate moves to de-list to
free themselves from the yoke of trying to please an irrational tyrant.
Others simply sigh and resign themselves to waiting for sanity to return
to market pricing, bearing in mind Keynes' famous dictum as they do so.
Just in case there is anyone out there who cannot instantly recall said
dictum, Keynes' warning was that "the markets can remain irrational for
longer than you can remain solvent". Which is just another way,
actually, of saying don't bet on the bottom till it bottoms. Just
because you think a stock is priced too low, doesn't mean it's going to
go up any time soon - and it may go lower still.
However, what looks to be irrational or at best understandable as a wild
amplification of a minor negative - something markets can do from time
to time as investors overreact and "herd behavior" sets in - can
occasionally have a more rational explanation.
Apple provides an excellent case in point. The stock has a long history
of soaring rallies and massive sell-offs. Why is this important? As
arguably the most successful and iconic company in America, and as a
company that has a reputation for rewarding buy-and-hold investors if
they can ride out its price troughs, Apple is a major component in the
portfolios of big institutional funds across advanced markets. Fund
managers know that by maximizing their allocation to Apple, they are
giving themselves a very good chance of outperforming over the medium
term.
In an excellent blog featured in Seeking Alpha, Jason Schwarz points out
that the key to understanding Apple's huge sell offs from time to time
lies in the fact that most fund managers will have a rule that says that
any single stock cannot be more than a certain percent of their total
portfolio. The reason for this is to honor the idea of diversification
as the best way of protecting capital. If you follow this idea of a
restriction on the percentage any one stock can have allocated to it,
then it follows that when Apple is doing one of its major up-runs,
adding very substantially to its price, as happened when it went from
$500 to $700, the total value of Apple holdings in many fund portfolios
rapidly exceeded the allowed allocation. So the fund managers have to
re-balance their portfolios by selling off a chunk of Apple stock to
bring the allocation to Apple back within their policy constraints.
If just one fund manager does this, in general unless they are holding
vast amounts of Apple stock, it makes no difference to Apple's share
price. However, since, as we have said, holding Apple is a winning
strategy for so many funds, what happens when Apple's price roars up is
that a number of funds get pushed over their single stock allocation for
Apple, and they all tend to get pushed at about the same moment. So the
inevitable result is a sudden glut of Apple selling with large amounts
of stock coming on to the market, driving the price down. As this
happens, other managers who might not be over their allocation, but who
have done very nicely from Apple through the up run, decide to sell and
take profit - knowing that in all probability, they will be able to pick
up those same shares at a discount a bit further down the line. (Sell,
wait for the price to drop sufficiently, then buy again before the next
up-cycle kicks in). The net result of all this is that Apple's price
plunges even although all the fundamentals are good:
"Suppose you were a mutual fund manager and your strategic models
allowed for a maximum 8% allocation in any individual stock. What would
have happened to your Apple holdings in 2012? As of September 21st,
Apple was up 74.9% year-to-date. Apple allocations at the largest mutual
funds had grown to between 13% and 15% of total holdings with the
fiscal year end approaching on October 31st. Because of Apple's
strength, because it was such an outlier when compared to the rest of
the market, these money managers were forced to re-balance their
portfolios in order to comply with their risk models. The Apple
slingshots, or in other words the deeper than unexpected sell-offs, are
caused by systematic institutional re-balancing."
That is it in a nutshell, Schwarz says. Forget conspiracy theories about
hedge funds, forget any number of "trigger" events for the sell off
that are touted in the press,
re-balancing is the real driver.
And once the institutions have finished re-balancing, and the ripple
effect from that re-balancing has died away, Apple will be on the rise
once again.