Things were proceeding so well for stocks in their recovery from getting hammered over coronavirus fears. We got drunk and overdid it, we sobered up, and now we’ve hit the bottle again.
For many, it can be very difficult and even maddeningly so to try to figure out what drives the stock market day to day. They might think that the market went up too much or went down too much in ways that exceed their own sense of proportionality, how they think that the market should have reacted based upon their own personal opinion versus what actually happened.
We try to do our best to explain things in a post-mortem fashion, taking our own perspective and using it as a template and then try to reconcile the actual event with our understanding. No matter how well we may feel we understand the market though, the trading doesn’t always proceed the way that we think it will, in a way that we may pass off as irrationality.
The biggest problem with this approach to understanding markets is actually the presumption of rationality that we make. We need to be careful in assuming anything, and especially assuming rationality, as among our kind, irrationality is a powerful force, and in many cases, overpowers rationality in the same way that protestors are overwhelming police forces around the country these days.
Our species is much more driven by emotion than reason, which doesn’t mean that reason does not exert its influence, but when emotion gets tweaked up enough, it can simply take over and cause us to behave pretty irrationally indeed.
Stock markets are certainly no exception to this, and the extent that emotions can drive stock prices is very well known among those who actually pay attention to these things. Those who do not realize this are doomed to becoming confused when markets overreact, either by way of exuberance or by fear.
Fear is especially powerful and can exert a particularly powerful effect on stock markets, which we have ample opportunity to observe this year in the midst of all the fears about COVID-19. We panicked earlier in the year, and then we came to our senses and gained most of that back over the next while, which can be seen as testimony to the extent of the fear-driven overreaction that we allowed to happen previously.
If anything, the actual events with the pandemic and our response to it were worse than we may have reasonably expected, not so much with the outbreak but certainly with how we hid from it and took such draconian measures against it. The fall and subsequent rise can be completely explained by fear levels spiking and then diminishing, where we feared that the sky was falling and then later came to realize that it actually wasn’t.
This is not to say that the massive quarantine that we placed ourselves under wasn’t that notable, and in fact it produced one of the most devastating economic impacts of all time. While much of it is temporary, no one doubts that there will be lasting effects that will persist for considerably longer than it takes to fully lift the quarantine, a view that Jay Powell of the Federal Reserve shared with us on Wednesday.
Powell did not tell us anything we did not know, at least among those with any sort of real awareness of where our economy is now and the challenges it will face to fully recover from this lockdown, but as he shared this, the market seemed to become scared by it and we saw a notable sell-off happen over the rest of the session.
It does not make sense from a rational point of view to become scared by a speech that did not share any new negative information, and this should have been viewed as a real positive, especially the commitment that Powell made that they are not going to pull their incredibly high level of support while it is still needed.
Their raising rates back up or pulling back on their huge support of financial markets directly as we recover more was a real worry, and even though it was more reasonable to expect them to continue on for quite a while, hearing Powell say that they definitely will certainly should have made us feel better, not worse.
Powell even dealt with the worry that inflation heating up isn’t something they see happening anytime soon, and given that this was another real worry and not a small one either, this should have also soothed nerves and bolstered our confidence that the Fed will remain all in on our side for as long as it takes, which was exactly the message that was delivered on that day.
Somehow though, this all served to scare some people, and as irrational as that may be, irrationality is very alive and well in the stock market. We can’t rightly say that the market should not be reacting a certain way, and the problem with our thinking that the market’s reaction in either direction is unreasonable attempts to impose a condition on it that it is not restrained by.
What happened the next day, on Thursday, was off the charts irrational as far as these things go, but once again, the market does what it does and when it becomes afraid, it can turn its back on the rationality that we assume it is guided by and even go crazy.
In the history of the Dow, there have only been three days where we’ve lost over 1,800 points in a single day, all back in March. This was at a time where the outcome of this pandemic was less clear, when many felt that this was the biggest health crisis the world has ever seen, with millions of deaths. Paired with the lockdown, this meant that many were left to wonder how long it may take to get things opened up again, with the potential to lay the economy to waste if this went on for too long.
In the end, once we got better control of our senses, the stock market ended up deciding that the amount we gave back these days, like the perceived threat, was very overdone and we took back the majority of it.
Panic Doesn’t Need to Make Sense, and Usually Doesn’t
This did give us a sense of what it takes to send markets reeling that much, with panic running in the streets in the way it did, and losing over 1,800 points in a day back then was at least in accordance with the fear that people felt, with the situation so undefined in their minds.
To see such a thing happen on Thursday, with the current situation akin to a finger poking now versus getting stabbed back then, simply defies the imagination, but only if we imagine that the stock market is moved by what we could call a sensible sense of proportionality.
Given that Thursday produced the fourth biggest point loss of all time, right up there with some of the all-time panic selling we’ve ever seen, you would think that the source of this panic would be very obvious. We at least should be able to come up with a dramatic event to pin this on, not have such a thing arise seemingly out of the blue like it just did.
The consensus here is that we panicked because the fear of a drastic increase in COVID-19 infections, being driven by the “spike” in infections that we are seeing now. No matter that infections aren’t spiking, and the only way to explain this is that people’s pent up fears about this happening finally exploded, like a dam bursting.
Coronavirus cases are not spiking in the United States right now and have been in decline for quite a while now in spite of the acceleration of the testing that we’ve been doing over this time. We don’t even have to account for the effect of increased testing, when you see claims of cases spiking but they aren’t spiking, they really aren’t spiking.
While people are claiming the problem is the number of infections going up in just a few states, states that are earlier in the infection phase and may still be waiting to peak, we need to realize that if it is the United States that we are worried about, which is clearly the case, we need to look at the whole picture and not just a few states like people want to do now.
This wouldn’t be so bad if not for the fact that cases aren’t actually spiking in states like Texas. Cases aren’t even going up much there even though they are testing more now which would serve to elevate the numbers by way of discovering more infections.
Texas did set a record for the number of daily infections on Wednesday, not in a way that could be described as a spike with any sense of honesty, as spikes stand out by their magnitude, a lot higher, not just a little. The number of cases in Texas overall hasn’t risen very much at all over this time, in spite of higher testing, which has been sufficient alone in explaining this phenomenon, meaning this represents only a nominal change that cannot even be considered without looking at the net effect.
The net change can only be measured by the percentage of people that we find infected, but no matter, because this does not need to be about actually thinking about these things beyond just having a sense of fear and then allowing that to guide our thoughts and actions.
This might only be a straw, but it can be the one that breaks the camel’s back as it sends it toppling to the ground. The number of infections in Texas may have dropped back down to a more typical number lately on Thursday, but the straw has already been cast and it only took the act of casting it to unleash market panic the day after cases “spiked.”
Texas is still proceeding with their Phase 3 of opening up their economy more, as state officials such as Lieutenant Governor Dan Patrick sees these concerns as inconsequential and unwarranted. Patrick is relying on reason to interpret this, and this should at least be expected from our politicians, even though they so often clearly breach this duty.
Market Overreactions Can Be Fun and Profitable, Like the Last One Was
The stock market has no such duty and is infamously fickle, and can choose to be as afraid as it likes and can rely on whatever reasons they wish to be afraid, whether they make sense or not. Thursday’s market crash stands alone in its gap with reason, magnifying concerns to an extent never seen before.
This does not mean that it was not appropriate though, as it can only be inappropriate when it conflicts with our beliefs of appropriate. The market gets to do whatever it wishes though, and when we think that it should act differently, we are only admitting our ignorance, whether we realize this or not.
The market does what it does, including producing the fourth biggest point loss of all time on a lark. Investing is a thinking game, but we need to be thinking about the right things, not how it was supposed to go and didn’t, but how it did go and what we may learn from this to better prepare us for tomorrow, the part that actually matters.
This move gives new meaning to the idea of a market overreaction, and when markets overreact and we recognize it, we put ourselves in a position to profit.
As we sold off, those who are disposed to get out could have easily done so early in the trading day, where we gapped down over 900 points and then went even lower. Knowing that the market was probably freaking out about the coronavirus made this determination much easier to spot than otherwise, and it didn’t matter if this was or wasn’t appropriate, it was happening and happening in dramatic fashion.
Just like we saw that the initial selloff on this issue was very much overblown, and that one did involve some real concerns and not just imagined ones like we have now, we can do the same with this one, only this one is likely to be much more temporary.
The market has gotten pretty drunk before but they actually passed out this time. If the initial crash was a combination of valid concerns and drunkenness, where the drunkenness caused these concerns to be blown out of proportion, Thursday was pure drunkenness, and one that we should be able to wake up from once we do start to sober up enough.
We spoke of the effects of downward momentum in yesterday’s article, and we sure saw this in full force on Thursday. Downward momentum by itself accelerates the selling, where the decline in itself increase the extent of the decline.
It’s not that a lot of investors are so put off by intraday moves of any magnitude that they participate in very much, as this barely touches their threshold of concern that they would bail on, and a great many didn’t even bail during the entire collapse the last time we were scared.
It’s traders that do the dirty work here, if we want to call it that, and the idea here is to profit by this by getting out, waiting for things to calm down, and then get back in at a lower price. The difference between where you got out and where you got back in is your profit with the trades, and when markets are falling this much, there is easy money to be made. This is also the best time to be short, and there’s a lot more short action out there than most investors imagine
There are also the traders that were in positions that have now turned soured, and traders need far less to get them out of their trades. This can create a domino effect where those with the lowest tolerances get out first, causing the price to drop to where the next set is ready to bail, and so on down the line.
This does eventually become exhausted, and when things have gotten to the point where there’s more people wanting in than wanting out, this is when we see the rebound.
The futures market is already speaking out about this, and by midnight ET, they have erased over 300 points of this huge loss. This does not mean that regular trading will take the ball and run with it as well once it opens, but the futures market is particularly sensitive to real risk and contributed significantly to the main crash, so if they aren’t worried, that does at least bode well.
It’s actually not all that hard to figure out where the market is going, as nothing beats just watching it. A few extra thoughts such as the selling being so exaggerated doesn’t hurt though, and together, we will watch and wait and be in the best position we can to react to what happens from here.