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Stepan Lavrouk
Stepan Lavrouk
Articles (414) 

The Anatomy of a Selloff: Understanding the Coronavirus Market Chaos

Why do selloffs happen?

March 24, 2020

Unless you have been living under a rock for the last several weeks, you will no doubt have noticed the stock markets have taken somewhat of a beating. The S&P 500 was down almost 34% as of Tuesday morning, and has given back all of its gains since Donald Trump became president. You will also no doubt have noticed the many takes equating this bear market to the 2008 financial crisis. This is understandable - I too believe that investors should learn from history (in fact, I often write about this subject).

However, we must also be wary of assuming that events will follow the same pattern as they did in 2008. Today, I want to look at the reasons why selling happens, how policymakers have responded, why they have done so and what that means for the stock market going forward.

It’s all about cash

Right off the bat, the big difference between this selloff and the one that hit the markets in 2008 is that it was caused by a non-financial event. There is an obvious difference between an exogenous event like a global pandemic and a housing bubble. That isn’t to say that there aren’t financial aspects of this crash that may amplify the chaos - for instance, the weak balance sheets of many large and important businesses, as well as the huge amount of low-quality corporate debt in the system. One of the biggest problems for companies of all sizes right now is how to come up with enough cash to fund their obligations and operating expenses. This is also true of investors and financial institutions.

How do you raise cash quickly? You sell anything you can at whatever the going price is. In the case of investors, particularly overleveraged ones, they sold assets that are traditionally viewed as stores of value: U.S. Treasuries as well as high-quality corporate bonds and gold. Many investors no doubt panicked seeing the falling prices, which just added to the chaos.

Businesses face similar problems. Typically, a company can tap the corporate debt markets to raise money by issuing bonds, but in this environment that is virtually impossible. Of course, there is always bank financing. But banks themselves are in trouble. When volatility rises, capital requirements often force banks to shrink rather than expand their balance sheets (because their assets are perceived as riskier) - this is one reason why the Federal Reserve eliminated reserve requirements for banks last week. Their selling only exacerbates the broader market rout even further. These phenomena help to explain why even the securities of solid companies with strong balance sheets can get hammered.

What has been done?

The Fed is taking extraordinary steps to alleviate the stress on the system by injecting massive amounts of liquidity. It has already announced an unlimited bond purchase program that will involve corporate bonds as well as government ones. My personal view is that it is only a matter of time before the Federal Reserve begins purchasing equities too. This is not so far-fetched. Former Fed Chair Janet Yellen has floated the idea in the past. The Bank of Japan has been buying equities for years.

What does this mean for investors? Well, this is where it gets tricky. On one hand, one would think this would make stock prices surge. On the other hand, the aforementioned Bank of Japan’s equity purchases have yet to push the Nikkei to new all-time highs. Moreover, it’s genuinely hard to predict what effect unleashing such a torrent of money on the market will have on the value of the U.S. dollar. Conventional economic theory dictates that such a policy will lead to runaway hyperinflation, but we have had more than 10 years of extremely loose monetary policy with little change in official inflation figures. So the answer is: no one really knows. The only thing that we can safely say is that we are now very much in uncharted waters. Tread carefully.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

Rating: 3.0/5 (2 votes)

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ezeazar
Ezeazar premium member - 4 days ago

very nice

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