In (July-August) 2012 and in (November-December) 2011, the stock market witnessed a a massive spike down in the market prices of midcap stocks. On each occasion, the sell-off lasted for a period of 1 month. In February 2013, there was a similar sell off again, only this time the sell off was much more violent and led to a virtual collapse in some stocks within 2 trading sessions.
Is there any commonality in such events?
I spotted three. Most of the midcap shares which fell victim to these events (1) had a large portion of their promoter holding pledged with financial institutions; (2) are fundamentally weak; and (3) not many research firms track them.
Such violent sell-offs and crashes could happen for either one, or a combination of reasons discussed below:
Margin Call Theory
Margin trading is a leveraging mechanism, which enables investors to take exposure in the market over and above what is possible with their own resources. It allows an investor to put as security (i.e. margin), their shares and get 3-4 times more exposure than the value of the shares put up as margin. The risk here is that if the investments made on this leverage decline more than the amount of security (i.e. margin), then the investor must either deposit more money or more security to top up their margin account. If this is not done, the financiers will sell the security in the market.
I highly doubt if triggerring of margin calls caused either of the above crashes. Had this been the case, the sell orders could have been tracked to the stock broker or entity which executed those orders in such large quantities. In any event, why would the financiers / financial institutions not disclose such a sale in open market. They are perfectly within their right to make such sales to recover their money once a margin call gets triggerred.
Operators and Bear Cartel theory
Bear traders make money by short selling the stocks i.e. selling the stock without actually holding it with the hope to buy it back at a lower price at a future date. The more a stock declines, the more money they will make.
Bear cartels target companies where promoters have pledged a big part of their holding. Together, they short sell shares of such company which results in a sharp spike down in the share price. Often, their aim is to hammer the share to a price below the trigger price of margin calls. Once the margin calls are triggerred, there is likely to be an even bigger sell-off in the share price as larger quantities of shares are sold by the financier to recover his money. It is possible that the above crashes also happened because of such bear cartels.
Panic Selling & Margin calls
Panic selling which follows any of these events further plays a part in driving down stock prices. Panic selling is a situation where investors do not exactly know why the share starts falling but they suspect the worst and start selling just because everyone seems to sell. No one looks at the business or fundamentals of the company once this happens.
Theoretically, any of these can be a reason for the above crash and for the ones which will happen in future. As for the above crashes, I really suspect a bear cartel at work, followed by panic selling. Mainly, there are 2 very strong reasons as to why this crash could not have been caused by pledged share sale.
First, financial institutions have a huge reputation to protect. What company would approach a bank (for a loan in future) which has in past done such fire sales on promoter holdings? This is the very last recourse for a bank. The scarcity of this measure is highlighted by the fact that no bank has yet sold off any kingfisher assets. Second, and the more conclusive reason – I analysed the July 2012 crash and looked at the shareholding patterns of affected companies before and after the crash.
As it is clear, the promoter shareholding did not fall and in most cases there was no substantial change in the percentage of shares pledged with financial institutions. Any more proof needed? Bear cartels are very much alive and kicking!
What precautions can you take as an investor? – Stay clear from companies where a large portion of promoter holding is pledged.