Fact and fiction blur together in market mayhem

COMMENT:INTERNATIONAL STOCK markets have been brutalised this week, suffering their fastest declines since the 2008/2009 global financial crisis. Is it a correction or a crash? Why now? And why do market declines tend to be so swift in nature?

Statistically, this is a correction, not a crash. Globally, the main market indices have fallen by over 10 per cent, whereas a bear market is ordinarily defined as a drop of 20 per cent. The US SP 500 index is merely back to levels seen last November, and is comfortably higher than it was a year ago. Furthermore, it’s over 70 per cent above its 2009 low point.

However, the speed and breadth of this correction is striking. Thursday’s 4.8 per cent fall in the S&P 500 was the largest one-day drop since the dark days of February 2009. It has suffered the biggest nine-day drop – over 12 per cent – since March 2009. Of its 500 component stocks, only three rose on Thursday. The indiscriminate selling is further indicated by the fact that just 4 per cent of stocks are trading above their 50-day moving average.

The Vix, the so-called panic or fear index, remains well below levels recorded in late 2008/early 2009. However, current readings are indicative of market panic, and Thursday’s jump was the biggest one-day gain since sub-prime mortgage fears gripped markets in February 2007.

The main US investor sentiment survey show that bearishness is very high, if not remarkably so – it’s at levels last seen in May 2010, and nowhere near 2009’s nadir. However, this week’s increase in bearishness is the largest weekly gain since July 2006.

Selling has been even more intense in Europe, where market volatility has increased for seven consecutive days, the longest such streak since October 2008.

One might ask why. The US debt ceiling crisis was averted this week, while euro zone debt woes and the slowdown in the US economy were “extremely well known prior to this week”, said market strategist and blogger Barry Ritholtz. That’s echoed by another money manager and blogger, Cullen Roche of the Pragmatic Capitalism blog, who argued that this week’s market concerns have been “pretty obvious” for some time.

Market movements are not always easy to divine. One study that looked at 50 of the largest US market moves found that media explanations tend to be tenuous, if not fictional. Behavioural finance expert Robert Shiller writes that they included “such relatively innocuous statements as ‘Eisenhower urges confidence in the economy’, ‘Further reaction to Truman victory over Dewey’ and ‘Replacement buying after earlier fall’.”

Analysts remain divided as to the reasons behind the greatest one-day crash in history – October 19th, 1987, or Black Monday, when US indices fell by over 22 per cent. George Soros attributed the collapse to a simple change of opinion by a forecaster who was influential at the time, saying this was the “crack that started the avalanche”.

Less reported reasons may include the triggering of stop-loss orders, the breaching of important technical support levels and computer algorithms, which are an increasingly important part of trading.

What’s undeniable, however, is that human psychology plays an enormous role in market panics.

Behavioural finance pioneer Daniel Kahneman, a psychologist who won the Nobel Memorial Prize in Economics in 2002 despite never having taken a course in economics, has shown that the pain of a dollar lost is more than twice as great as the joy of a dollar gained. That’s likely a factor in the speed of market declines, which tend to be sharp and swift, in contrast to the steadier incline that typifies bull markets. When losses mount, a stampede can develop.

Traders are acutely conscious of this potential stampede – “Never catch a falling knife” is one of the oldest market adages. Even Soros, a contrarian-minded trader, has warned in the past that one should be “cautious about going against the herd” as one is “liable to be trampled on”.

“Nothing matters until it does,” Cullen Roche warned in an investor letter last month. Yesterday, he had a new headline that reflected the market turn. “Suddenly it all matters”.