Opinion: The hidden, yet powerful, forces behind a bad sell-off in the stock market

The electronic index is displayed outside the Toronto Stock Exchange tower.Christopher Katsarov/The Globe and Mail

Interest rates started rising on it, but something else took hold — and now, mysterious but powerful forces are exacerbating the pain of the stock market crash.

When tech stocks began falling last November, it was widely understood that shareholders were selling in response to the threat of higher interest rates. Consumer prices were on the rise, and central banks had to move to contain inflation. But growth stocks often struggle when rates are up.

Six months later, projected interest rate increases were supposed to be factored into stock market valuations, but the track hasn’t stopped. In fact, it has spread to the broader market, with the S&P 500, the benchmark for North American stocks, down 14 percent so far.

There are some obvious explanations for this. To start, software is the new oil sector, and the S&P 500 is now heavily weighted by technology stocks. Powerful companies such as Apple Inc. and Amazon.com Inc. So much so that it makes up almost a quarter of the index.

But there is a lot. There are other very powerful forces at play as well, and they rarely get enough attention or respect. The most important of them: the role of margin debt in market declines, the record inflation in the price of financial assets since the 2008-2009 global financial crisis, and the most difficult – the irrational psychology of the investor.

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Throughout the second half of 2021, there was a fierce debate among economists about whether the rise in the prices of everyday goods was just temporary, or something more systemic. What was missing from this debate was that there was indeed inflation in the global economy – but it was in financial assets.

This phenomenon has received more attention lately, as it helps explain why housing prices are rising. But the stock markets have also experienced hyperinflation and – arguably – this is not getting enough attention.

The Federal Reserve Bank of St. Louis, a regional branch of the US central bank, tracks the value of the Wilshire 5,000 – a broad measure of the total US stock market value – relative to US GDP. In 2000, at the height of the dot-com boom, the value of the stock market was about 1.4 times the gross domestic product of the United States. Then the ratio went down and it took about 20 years to rise to that level.

After being hit by COVID-19, the percentage far exceeded the dotcom heights. By the beginning of October last year, the stock market value had risen to 1.98 times GDP.

Some people will use the term “bubble” for such a buildup – and for the tech sector, it clearly was. It’s too early to say that for the entire market, but financial metrics tend to return to their averages during the correction. There is still plenty of cash to be moved out of the stock market before it even drops to internet lofty heights again.

Exacerbation of this threat: a lot of this money can be moved by force, because a lot of it was borrowed.

Margin debt is a measure of how much money has been borrowed for investment purposes. By October 2021, US investors had borrowed $936 billion to put it on the market, up 72 percent from February 2020, and well above the historical average. As interest rates rise, the cost of borrowing this money for investment increases.

However, the biggest fear is that all of this debt will create margin calls while the markets deteriorate. Using debt to invest boosts gains in bull markets, but the opposite can happen in bear markets, because lenders will require margin clients to provide more capital as a hedge against trading bets. If the client has all of his excess capital in other stocks, he will have to sell some positions, adding pressure on falling stock prices.

In most downturns, what it takes to end the downward spiral is some conviction from investors sitting on cash that stocks are cheap. But this time, the ratings are hard to measure. Crucially, old metrics like the P/E ratio rarely apply to tech stocks, because many of these companies aren’t making profits, and they haven’t made them at all.

As for tech activists, earnings growth is slowing, as seen with Amazon this week. “Future outlook points to another slowdown in growth in the second quarter, as well as a long-awaited hit to profit margins,” Liz Ann Saunders, chief investment analyst at Charles Schwab, wrote in a note to clients.

At the same time, one of the driving forces of the market over the past two years – retailers – is disappearing. Traders in the late twenties and early thirties poured money into stocks, and at some point in 2021 they accounted for half of all trading in Canada.

But they quickly fled, which is why Robinhood Markets Inc’s share price has fallen. It has increased by 73 percent since the retail trading platform went public last year, and laid off the company. 9 percent of its employees last week.

With retail traders turning volatile, some large institutional investors may have to do the heavy lifting to turn the markets around — something Warren Buffett began doing by spreading his company’s money. But they also have a lot to sort out – especially the chaotic economic background.

What it all means is that no one is sure what natural look they like anymore – and that’s where investor psychology is the scariest, because irrational behavior can become the norm. The last few days of trading are proof of that.

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