How to escape the “forced sale” snowball

By Kim Iskyan

Making a snowball by rolling it down a hill is fun. Unless the snowball becomes so big that it can kill you.

When stock markets fall three or four (or more) percent in a day - as U.S. markets did on Wednesday and many Asian markets did on Thursday - the biggest question in my mind is this: Who is going to be forced to sell the next day?

You see, when markets fall, they sometimes pick up downward momentum because of the financial market equivalent of a snowball rolling downhill.

(Just to be clear… I do not believe this is what's happening now. But: If markets suffer a few more big down days, it could start soon.)

The snowball I'm referring to in this case is triggered by something called a forced sale. It typically happens when an investor needs to sell an asset immediately (no matter the price) in order to raise cash to meet a financial obligation. That can be when your broker lends you money to buy shares - but if the value of your account falls below a certain level, you need to sell some of the holdings in your account to raise cash to return to your broker. This is more commonly referred to as a margin call.

In normal market conditions, you sell only what you want to and when you want to. But if you can't wait - like when you're issued a margin call - and must sell at once, you're at the mercy of the buyer. In the middle of a frenzied decline in markets, buyers can be very demanding, and push the price lower and lower. So this situation leads to lower prices… which in turn triggers new margin calls… and even lower prices.

The same thing can happen with property

Another way of looking at this? Let's say you buy an apartment as an investment, and plan to use the rental income to cover the mortgage. Things go fine for a while, and you're thrilled that your tenant is paying your mortgage.

But then the local economy sours, and the real estate and rental markets weaken. The person who was living in your apartment leaves for a job elsewhere, and you can't find someone to take his place. Even though no one's living in your apartment, you still have to pay the mortgage, of course. So when the mortgage payment is due - after a few months of dipping into your savings - you scramble to find the cash, and wind up having to sell your car. Since you had to sell in a hurry, you get a bad price for it (buyers can sense your desperation!), but at least you're able to make the next few payments on your rental property.

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 apartment. But you're not alone. Other people had the similarly bright idea of buying apartments and renting them out. They've also lost their tenants - and can't pay their mortgages.

So now there are a lot of properties going up for sale by desperate sellers who don't want to be foreclosed (that is, have their property taken away by the bank that holds the mortgage). There aren't many buyers and there are lots of sellers, so you have to sharply cut the asking price of your apartment. As a result, when it finally sells, the proceeds aren't enough to cover the outstanding loan - so then you also have to sell your motorcycle in a hurry, at a fire-sale price. That's another forced sale, and another loss. It's a snowball effect that can destroy your net worth faster that you can imagine.

Back to stocks

As I said, when this happens in financial markets, it's bad news. Many investors, both individuals and at hedge and mutual funds, borrow capital to buy securities "on margin". So they're 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.

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.

A few years ago, something similar happened in commodities. A sharp decline in the price of oil was creating forced sellers. Sovereign wealth funds (big, state-owned investment funds) in some oil-producing countries, such as Saudi Arabia, were probably being forced to sell some of their holdings of shares. They wouldn't have been getting margin calls, but the government - facing lower revenues because of the lower oil price - needed to fill budget gaps, and was looking to the sovereign wealth funds to help. So they had to sell holdings, in a hurry, in the middle of an oil market downturn.

During corrections in markets, forced selling can get ugly. And forced selling is self-reinforcing - forced sales trigger more forced sales as markets decline.

If that happens, do this

As I said, I don't think this is happening now - at all. But if things get sticky, what should you do to avoid being caught in the snowball of forced selling?

It's kind of obvious - if you think of it beforehand…

  1. 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. (As I've said before, there's no better hedge than cash.)
  2. Watch your stop loss levels - and adjust them thoughtfully so that you don't reach the point where you're forced to sell a good company. It's a million times better to sell on your own terms and at your own time.
  3. Ensure that your portfolio is sufficiently diversified, with assets that are as uncorrelated as possible. (Sometimes it's the obvious things that are the most difficult.)
 

Kim Iskyan
Kim Iskyan is the publisher of Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets. He's been quoted in the Economist, The New York Times, the Wall Street Journal, Barron's, and Bloomberg, and has appeared on Fox Business News, China Central Television, and Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications. For more of his insights, Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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