Panic Perspective, Part I

There is not a single shareholder who is not aware of the significant loss in value that has best U.S. stocks over the last three weeks.  The U.S. stock market toppled with such speed and force, all new records have been set.  Financial market pundits repeatedly begin commentary with “never before…” and “not since….”  A chart for the S&P Small Cap 600 Index tells the story well.  Year-to-date the index has lost more than one-third of its value.  Ouch! Few investors can tolerate losing one third of their wealth or even half that amount. 

Professional traders and individual investors alike have had to scramble to unwind leveraged positions.  Indeed, some of the downdraft is actually as a consequence of the rapid, disorderly deleveraging action that began in early March 2019.

It would seem the lessons have already been forgotten of the Great Depression and the financial crisis in 2009 to 2010.   Global debt levels have mounted as central bankers, independent in name only, have one after another caved into pressure of politicians to reduce interest rates for the sake of economic growth.  The U.S. economy in particular seems to have gone on another binge of excessive leverage, especially in the financial sector.  The U.S. Federal Reserve under the chairmanship of Trump appointee Jerome Powell, has been quick to clip interest rates after well targeted threats by Trump in social media.  

It was only a matter of time before a lit match was flung into the dry tinder of margin loans and hedged positions.  No one could have anticipated a health crisis could start such a fire, but here we are.

Yet again bond market traders and policy makers have been caught off guard by the fragility of the U.S. treasury bond market.  Desperate to raise cash for significant new redemptions, fund managers were met at the market door with unexpected illiquidity in the off-the-run segment of the treasury bond market.  Fewer bond broker-dealers and restrictions on balance sheet leverage has reduced trading capacity even in the best of times.    

Historians will sift through the ashes for years to come, pinpoint just where the skid marks left the road.  Still in the midst of the crisis, the stock chart and timeline shown below provides a few clues.  We notice that the Shanghai Stock Exchange Index opened dramatically lower after the new year holiday, but recovered quickly.  It seemed that China investors were confident that the light at the end of the tunnel was indeed an end to the crisis.  Lockdown policies and work stoppages appeared to be working in China and had calmed the public.  

Then things started heating up in the U.S. It looks as though the panic in the U.S. stock market had a spill-over effect on the Shanghai Index.  That panic is registered in the S&P 600 Small-cap Index as shown in the second chart.

What triggered the U.S. stock market sell-off?  Acknowledgement of demand destruction from the shutdown in China production and the impact on 2020 earnings?  New understanding of the coronavirus and the reality of unfettered spread of the virus in economic terms seems to have taken root in the final week of February 2020.   

The next post attempts an answer.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.