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 dictumas 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.
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 percent allocation in any individual stock. What would have happened to your Apple holdings in 2012? As of September 21st, Apple was up 74.9 percent year-to-date. Apple allocations at the largest mutual funds had grown to between 13 percent and 15 percent of total holdings with the fiscal year end approaching on October 31st.
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.
By Anthony Harrington