Opinion: The hidden but powerful forces behind the nasty stock market sell-off

The electronic ticker screen outside the Toronto Stock Exchange Tower.Christopher Katsarov/The Globe and the Mail

Rising interest rates started it, but something else took over, and now mysterious but powerful forces are compounding the pain of the stock market crash.

When tech stocks began to plunge last November, it was widely understood that shareholders were selling off in response to the threat of higher interest rates. Consumer prices were skyrocketing and central banks needed to act to contain inflation. But growth stocks often run into trouble when rates rise.

Six months later, the expected increases in interest rates should have been factored into stock market valuations, but the slide hasn’t stopped. It actually spilled over into the broader market, with the S&P 500 Index, the benchmark for North American stocks, down 14 percent year to date.

There are some obvious explanations for this. Software is the new oil sector to begin with, and the S&P 500 is now heavily weighted by technology stocks. Staunch stalwarts like Apple Inc. and Amazon.com Inc. have grown so large that they account for about a quarter of the index.

But there is much more. Other very powerful forces are also at play, and they rarely get enough attention or respect. Chief among them: the role that margin debt plays in market downturns, the record inflation in financial asset prices since the global financial crisis of 2008-09, and, most prickly of all, the irrational psychology of the investors.

‘It’s getting real now’: Stocks end a volatile week lower as markets grapple with how tough the fight against inflation will be

US retail investors scooped up stocks during Thursday’s market crash

Throughout the second half of 2021, there was a fierce debate among economists about whether the rise in prices for everyday goods was merely transitory or something much more systemic. What was missing from this debate is that there was already inflation in the global economy, but it was in financial assets.

This phenomenon has received more attention lately, because it helps explain why house prices have skyrocketed. But stock markets have also experienced intense inflation, and that has arguably not received enough attention.

The Federal Reserve Bank of St. Louis, a regional branch of the US central bank, tracks the value of the Wilshire 5000, a broad measure of the total value of the US stock market, relative to the US gross domestic product in 2000, at the height of the dot-com boom, the value of the stock market was about 1.4 times US GDP. Then the ratio tanked and it took about 20 years to get back up to that level.

After the COVID-19 hit, the ratio far exceeded dot-com heights. By early October of last year, the value of the stock market had ballooned to 1.98 times GDP.

Some people will use the term “bubble” for such a buildup, and for the tech sector, it clearly was. It’s too early to say that for the entire market, but financial metrics tend to return to their averages during corrections. There is still plenty of money to be taken out of the stock market before it falls back to dot-com lofty heights.

Exacerbating this threat: Much of this cash could be forcibly moved, because much of it has been borrowed.

Margin debt is a measure of how much money has been borrowed for investment purposes. By October 2021, US investors had borrowed $936 billion to put on the market, 72% more than in February 2020 and well above the historical average. With rising interest rates, the cost of borrowing this money to invest is getting more expensive.

The biggest fear, however, is that all this debt will create margin calls as markets stall. Using debt to invest improves profits in bull markets, but can do the opposite in bear markets, because lenders will require their margin clients to put up more capital as a cushion against trading bets. If a client has all of his excess capital in other stocks, he will be forced to sell some positions, which puts further pressure on stock prices to fall.

In most recessions, what is needed to end the downward spiral is some conviction from cash-sitting investors that stocks have gotten cheaper. This time, however, it is much more difficult to measure valuations. Crucially, old metrics like price-earnings rarely apply to tech stocks, because many of these companies don’t make money and never have.

As for tech stalwarts, earnings growth is slowing, as seen with Amazon this week. “Looking ahead, expectations point to another growth slowdown in the second quarter, as well as a likely long-awaited hit to profit margins,” Charles Schwab chief investment strategist Liz wrote in a note to clients. Ann Sonders.

At the same time, one of the driving forces of the market in the last two years, the retailers, is disappearing. Traders in their 20s and 30s invested money in stocks, and at one point in 2021, they accounted for half of all transactions in Canada.

But they have been quick to flee, which is why Robinhood Markets Inc.’s share price is down 73 percent since the retail trading platform went public last year, and the company has laid off 9 percent of your staff last week.

With retail traders getting jittery, some big institutional investors may have to do the heavy lifting to turn markets around, something Warren Buffett is starting to do by rolling out his company’s cash. But they, too, have a lot to sort out, particularly a messy economic background.

What all this means is that no one is sure what normal looks like anymore, and that’s when investor psychology is scariest, because irrational behavior can become the norm. The last trading days are proof of that.

Your time is valuable. Get the Top Business Headlines newsletter conveniently delivered to your inbox morning or night. sign up today.

Add Comment