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Why are stock markets falling so deep?

Until the 19th of February 2020, U.S. American and European stock markets saw unprecedented growth, with all-time-highs being a phenomenon investors had become accustomed to. Stock indices, such as the Dow Jones and the Standard & Poor 500 in the U.S. or the DAX in Germany, track the performance of the stocks of a region or reflect a certain product type’s performance. The NASDAQ in the U.S., e.g., is heavily weighted towards information technology companies.

When attempting to analyse the behaviour of the markets, it is crucial to understand the importance of reciprocity. This is because there is a clear difference between individual, and aggregate decision-making. The success of the individual investor’s decision is dependent on how the price of the asset they invested in, develops over time. However, this development is the reciprocal process of aggregate price changes, meaning that by investing, one indeed reacts to former prices (= decisions), but also causes further reactions.

C-suite executives of public companies do understand this and have used this and low interest rates to their advantage over the last 6 years. Companies borrow money to buy back shares to artificially boost share prices, which serves the dual role of maximising year-end bonuses and averting balance sheet crises, as repurchases in fact decrease the per-share tangible assets while companies pump up the price. Goldman and Sachs’ Kostin noted, “without company buybacks, demand for shares would fall dramatically” and that “companies will likely continue to fund spending by drawing down cash balances and increasing leverage.”

The consequences of these actions were not only that institutional and retail investors developed a false confidence in the value of the companies they had invested into, meaning that they overestimated their value and kept pushing it higher, but also that both companies as well as investors became illiquid. The point of illiquidity is crucial when contemplating the falling prices. Due to this overconfidence in the performance of the stock market, investors believed that the best use for their money was not as a store of value in bank accounts, but rather in stocks and government bonds.

This implies that even though those investments may yield large returns for the investors, it is not necessarily the case that these returns are already realised. When – as is now the case – institutions and individuals in fact need money for their day-to-day bills, they must liquidate those positions. By defining a target price, they signal both how much they need and how much they assume the asset will be worth at a certain point in time. What we cannot presume is that ideal trades are possible, as no investor knows whether the price they are looking at is indeed a ‘local minimum’ nor whether their selling target is a local – or global – maximum, implying maximal returns on the investments. Thus, even liquidation of assets is driven by the aforementioned reciprocity or reflexivity which contributes to the speed of the price movement.

At the time of writing (early April 2020), “[t]he price declines have led to higher bid-ask spreads and greater difficulty for investors in finding buyers or sellers of stocks at desired prices. ‘Liquidity has evaporated within U.S. equity markets, magnifying index-level moves during the ongoing bear market’”, writes.

As U.S. employment claims reach 6.6 million because of the isolation measurements against the COVID-19 pandemic, productivity drops massively which in return signals investors whether current price levels in the markets are justified or not. The negative sentiment for 2020 will further weaken prices.

Edited by: Patrick Lehner

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Nov 19, 2021

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