Accelerate Monthly -The Reverse Crash and the Unpredictability of Macro Shocks

October 15, 2024 — Stock market crashes, when securities experience a rapid and severe drop in price, are some of the most memorable economic events for investors, given the discomfort and distress they can cause.

Crashes typically happen when panic selling occurs, and investors lose confidence in the market or broader economy. These declines are often swift, sometimes taking place over just a few days, and can result in substantial financial losses for investors in the short term.

Markets can crash for several reasons, including:

• Economic Instability: Recessions, high unemployment, or other economic downturns can lead to decreased consumer spending, which negatively impacts companies’ earnings and stock prices.
• Financial Bubbles Bursting: A period of overvaluation (when stock prices rise far beyond their intrinsic value) often leads to a crash when investors start selling en masse, realizing that stocks are overvalued.
• Panic Selling: Negative news or economic data can cause investors to panic, triggering widespread selling. This dynamic drives prices lower and fuels more panic, creating a vicious cycle.
• Political or Global Events: Events such as wars, political instability, or natural disasters can shake investor confidence and lead to sharp market declines.
• Speculation and High Leverage: Speculative trading, where investors take on excessive risk, combined with borrowing (leverage), can amplify losses and contribute to a crash.

The current generation of investors have experienced several notable market crashes over the past 25 years. The 2000 tech bust experienced substantial market declines concentrated in the technology sector, as a financial bubble combined with an economic contraction led to speculative excesses unwinding. The 2008 financial crisis, in which the housing bubble, fueled by risky lending practices, burst, leading to a global financial crisis and sharp declines in the stock market. More recently, fears of global economic collapse due to the pandemic led to a sharp and sudden drop in stock prices in early 2020.

Legendary investor Peter Lynch once said that “far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves,” referring to the idea that many investors try to predict, and subsequently sidestep, a stock market crash as not to suffer the emotional and financial consequences of being fully invested in risk assets as they suffer rapid declines.

While market crashes have been well-ballyhooed throughout history, their antithesis, market surges or “reverse crashes”, are less often discussed.

A reverse market crash is a rapid and significant surge in securities prices over a short period, essentially the opposite of a market crash. While the term “reverse crash” isn’t commonly used, this phenomenon represents a quick and violent market surge. It could occur for several reasons and would likely reflect extreme optimism or external forces that push investors to buy stocks aggressively, violently driving prices higher.

Unpredictable macroeconomic catalysts often drive reverse market crashes. For example, market coordination or manipulation, typically effected through government intervention, can feed swift speculative frenzies that can cause market prices to rocket skyward.

Last month, global markets witnessed a stunning reverse crash in the Chinese stock market after the People’s Bank of China unveiled a US$114 billion (Rmb 800 billion) war chest to boost the Chinese stock market by lending to domestic asset managers, insurers, and brokers to buy equities, as well as allocating cash to listed companies in order to repurchase their stock.

In response to the unprecedented government stimulus, market participants went euphoric. Commencing the last week of September, investors bid up the Shanghai Stock Exchange’s CSI 300 Index by more than 25% in a matter of days.

Concurrently, volumes of Chinese and China-adjacent stocks surged, as investors chased and contributed to the unprecedented rally. Seemingly overnight, Chinese equities went from persona non grata to must-have investments in the eyes of market participants.

Prior to China’s “bazooka” financial stimulus measures, along with a historic stock market surge, global investors resoundingly panned Chinese stocks. Look no further than the success of “ex-China” emerging markets ETFs. Flows into Chinese stocks had been moribund, and sentiment remained poor.

Throughout most of this year, investors’ disdain for Chinese investments was palpable. China ETFs experienced net outflows in thirty out of forty weeks of 2024. The Chinese government’s recent stimulus package reversed this trend, and did so in stunning fashion. Approximately $8.2 billion of capital inflows went into China ETFs over the past few weeks.

The size of the movement of capital was exceptional, as China equity funds experienced record inflows.

Nonetheless, reverse market crashes are not necessarily uniformly positive. Stock market surges, caused by unpredictable government stimulus measures, are by nature volatile and ephemeral. Chinese equities have been relatively weak thus far in October, as the FOMO and animal spirits of the initial rally wear off. While not necessarily benefiting long-only investors over the long term, due to the potentially temporary nature of the rally, China’s reverse market crash also damaged another contingent: short sellers.

Markets are more interconnected than ever. While long-short hedge funds in China were scrambling to cover their short positions during the unprecedented stock surge, knock-on effects were felt across global markets. In North American stock markets, low quality junk stocks rallied in tandem with Chinese equities, making for a challenging environment for hedgers, short sellers, and long-short equity strategies during the last week of September.

While market crashes and reverse market crashes represent opposing dynamics, both feature psychological factors such as fear and greed playing a significant role. Investors’ behaviour often amplifies the movement in either direction, contributing to extreme market volatility. Explosive market movements in either direction, driven by surprise macroeconomic catalysts, are inherently unpredictable. As such, instead of trying to position for a near-impossible to predict event, one should position a well diversified investment portfolio to be able not only to survive, but thrive, through the volatility with minimal psychological stress.

Accelerate manages five alternative investment solutions, each with a specific mandate:

• Accelerate Arbitrage Fund (TSX: ARB): Merger Arbitrage
• Accelerate Absolute Return Fund (TSX: HDGE): Absolute Return
• Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Multi-strategy
• Accelerate Canadian Long Short Equity Fund (TSX: ATSX): Long Short Equity
• Accelerate Diversified Credit Income Fund (TSX: INCM): Private Credit

Please see below for fund performance and manager commentary.

ARB generated a 0.4% return in another busy month for arbitrage.

The Fund invested in four new merger arbitrage investments, including a sizeable leveraged buyout with a go-shop provision, an industrial tie-up, an international gold merger, and a Canadian subscription receipts deal. In addition, the Fund invested in four new SPAC IPOs (out of a total of five that came to market in September). We are observing a larger contingent of repeat, experienced sponsors launch new black check vehicles.

Currently, ARB’s portfolio is 141.4% long, -13.4% short (154.7% gross), of which 44% is allocated to merger arbitrage (23% strategic and 21% buyouts) and 56% to SPAC arbitrage.

HDGE declined -0.2% for the month, bringing its year-to-date performance to 20.4%. The China stimulus-induced market rally had knock on effects throughout global markets, leading to a challenging month for hedged portfolios.

Specifically, low-quality junk stocks outperformed during the last week of September, although not dramatically. Most U.S. factor portfolios generated losses for the month. The long-short value, quality, and price momentum portfolios declined between -1% and -2%. Conversely, both the long-short U.S. operating momentum and trend portfolios generated positive performance. Nonetheless, multi-factor portfolios suffered a slight monthly decline due to the outperformance of short portfolios in the last week of the month.

ONEC returned 1.9% in September, as most alternative asset classes generated positive performance.

Gold continues its extraordinary bull run, gaining 4.6% for the month and 28.6% year-to-date. Our June memo, Why Gold Shines Bright in Investment Portfolios, outlined the thesis behind owning gold.

The Fund’s real asset allocation had a strong month, with its real estate investments up 3.4% and its infrastructure investments gaining 3.2%. Positive contributors to the Fund’s performance include its risk parity allocation, which increased 3.1% last month, while its commodities and managed futures allocations gained 1.3% and 1.0%, respectively. ONEC’s broadly syndicated loan and arbitrage allocations both generated less than a 1% return while private credit, absolute return, and long short equity were approximately flat for the month.

ATSX’s September performance was -0.1%, compared to the benchmark TSX 60’s 3.1% rally.

Multi-factor long-short investing was particularly difficult in the Canadian market, with short portfolios generally outperforming longs. For example, the top decile of undervalued Canadian stocks fell -0.7% for the month, while the bottom decile most overvalued stocks gained 8.5%. Moreover, the top decile of quality stocks fell -2.1% in September, as the lowest quality stocks rallied 7.1%.

Pop punk band Green Day once sang, “Wake Me Up When September Ends”. Overall, September was a month to forget for Canadian long short equity investors.

Private credit was unchanged for the month. Yields remain high, while NAV discounts abound in the secondary markets.

At month’s end, approximately 80% of the Fund’s private credit holdings are trading below their net asset value, and the portfolios average NAV discount is -5.7%.

Presently, INCM is allocated to more than 4,600 loans and investments, of which 84.5% are senior secured and 91.0% are floating rate. The Fund has a current underlying portfolio yield of 11.6%.

Have questions about Accelerate’s investment strategies? Click below to book a call with me:

-Julian

Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.