March 2020 will certainly be one for the history books. Investors first watched in horror as valuations plummeted by 20%, then were shocked to see markets rally significantly. It was a period of extreme volatility, with the benchmark volatility index hitting levels not seen since the 2008 financial meltdown.
The thing about periods of high volatility is that they tend to follow periods of low volatility. In the run-up to March, investors were treated to some of the lowest VIX readings in history. Volatility was low because there was broad consensus among investors that prices were going to continue rising - right up until there wasn’t.
The most important moment
All of the above is consistent with a theory of market crashes proposed by economist Hyman Minsky, which states that collapses in valuation are the result of unsustainable speculative activity during a bull market. Although this might not sound like exactly ground-breaking stuff - we have known about the damage that runaway bull markets can wreak since at least the Dutch tulip bulb bubble of 1637 - Minsky did formalize some of this thinking. A "Minsky moment" is the point at which an unsustainable rally finally breaks the market.
Now, as is usually the case with these things, it is only really possible to identify a Minsky moment after the fact. However, analyzing them can still teach us a lot about the anatomy of market crashes. Minsky believed that all extended bull markets would eventually lead to spectacular crashes, as investors became more and more leveraged. This is something that we seem to have rediscovered recently, just months after financial luminaries informed us that the “boom-bust cycle is over” - another hallmark of mountaintops.
So the longer a bull market lasts, the more debt people take on to invest. This can be visualized on a chart that compares gross domestic product to the amount of credit in the economy. At a certain point, people will start to borrow more than they are producing. Of course, at the beginning of a bull market, this isn’t an issue - credit is the basis for a lot of the economic growth we have enjoyed throughout history. However, it does become an issue when the investments become more speculative in nature.
High levels of debt will exacerbate market selloffs. It is normal for prices to go up and down, but at a certain point, investors become so heavily leveraged that they are forced to put up collateral if the value of their investments goes down even a little bit (this is called a margin call). They are forced to sell even those investments that are performing well, which exacerbates the selling and causes more chaos. Too much of a good thing can be bad, and that is as true of bull markets as it is of anything else.
Read more here:
- Peter Lynch: Here Is the Most Important Thing About Investing
- Warren Buffett: Here's How Ordinary Investors Can Benefit From Wild Price Swings
- Howard Marks: How Passive Investing Affects the Market
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