Why Do Markets Drop So Much During a Crisis?

As we watch the markets free fall around the world today it is worthwhile to take a moment to understand why this happens when there is bad news. After all, it is fair to ask why so the stocks of so many companies unrelated to those directly involved in the process see their prices go down. Let's take a short tour, using as our example the present crisis in the US financial sector.

Before starting let's also understand the mechanics of stock prices, andthe price of any security in an open market. It's all about supply and demand. If there are lots of sellers and few buyers at one point in time the price of the security will tend to drop until equilibrium is restored between sellers and buyers. Conversely, prices tend upward when there are few sellers and many buyers. It's an instantaneous effect. Other investors and speculators may then jump in as the price moves. There is no pricing god in the market - it's all people, programs and psychology.

Now let's consider factors that likely play into this morning's activity. We must also acknowledge there are huge numbers of players and while it is technically possible to track every trade (by regulators and governments) it is not possible to know why everyone makes those trades. Every trade has its buyers and sellers, and all have their unique reasons.

• Loss of confidence in financials: Our economy, including the value of currency, is largely supported by confidence in the entire system. Lose that confidence and investors head for the hills. They will take losses in low-confidence assets and hope to shift that wealth into higher-confidence assets. Gold and other precious metals usually benefit, though gold isn't up that much today.
• Lack of confidence is contagious: There is a secondary impact from those not directly involved in finance, such as you and me. The thinking of many is that if the experts are scared then so should I. Thus, more selling.
• Active trading rules the day: It doesn't matter if you and I decide to hold our investments through this crisis. Share price is determined by those who are buying and selling today, and which way the balance between them tips. This includes short sales, options and other derivatives. All it takes is one seller and one buyer to move the quoted price, and there are lots of buyers and sellers today.
  
• Mutual funds, including index funds: A large amount of personal investments, including RSPs, are not made directly in public companies but through intermediary funds sold to the retail market by banks and other financial outfits. When an investor sells units in these funds, and especially when there is an imbalance of outflows over inflows, the fund managers need cash to pay out those investors. Since these funds keep very low cash balances they need to raise cash by selling shares in the securities held by those funds. Thus, more selling pressure in the market.
• ETFs: Ditto.
• Hedge funds: Ditto. However, actual outflows are delayed since most funds only allow redemption at fixed calendar intervals. Nevertheless, fund managers may want to raise funds now in anticipation of future redemption. This is especially true of funds that are performing poorly, and there are lots of those right now.
• Second-order effects: As prices drop in the financial sector, the wealth of ordinary people suffers at least a paper reduction. As these numbers erode, people respond by slowing contributions to RSPs and RESPs, which reduces buying pressure in the market. People also tend to spend less which can impacts the future profits of companies selling discretionary products and services to consumers, and to companies that sell to those companies. This tends to cause (with more lag time) selling of shares of companies throughout the economy. Commodity prices also tend to fall, which is of particular interest to Canada, since less business activity reduces demand for commodities of all types, including metals and oil.
• Dollar impacts: When commodities fall the Canadian dollar is weakened because there is the implication that the future wealth of the economy is reduced. This can drive up the (local) price of some commodities and stocks that have strong ties to foreign currencies, and especially the USD.
• Third-order effects: As the dollar drops, exporting businesses may get a boost to their revenues and profits since their products and services become more attractive. This is unlikely to fully compensate for primary business impacts but will give the stocks of these companies better relative performance.

It's all a tangled mess because our economy has so many complex inter-relationships, domestically and to other countries. At some point there will come a new period of relative stability in the markets though it is very difficult to predict at what the price levels. I won't even venture to make a prediction. For now we sit and watch (and perhaps do some buying and selling) as this shock ripples around the world. Even as I type this the markets are bouncing off their lows, though there's no telling if this is or isn't a bottom.