Why does stock market fall so steep?

If we look at the stock market over the long term, we see that most of the time we are dealing with rising prices. This is true of both the world indices and the S&P 500, which includes the largest U.S. companies. There’s nothing strange about that, because we’re usually accompanied by inflation, which means nominal stock prices should go up. On the other hand, companies themselves are also designed to grow and generate more and more profits. That’s why rising prices are built into the stock market.

Unfortunately, boom periods have always been accompanied by corrections and stronger declines, which investors fear so much. Is it rational to fear temporary losses as we are almost certain to win in the long run? According to Warren Buffett, no, but not all of us are legendary investors. Losing capital says more about us than potential future gains, and a bear market or even a deeper correction can cause quite a bit of emotion. The chart below shows bullish and bearish trends for the S&P 500 Index since 1942. We view a drop of 20% or more from the top of the market as a bear market.

As we see it, a bull market produces an average total return on investment (stock price appreciation + reinvested dividends) of about 155%. A bear market reduces investors’ portfolios by an average of 32%. So why do we react so nervously to this? It has to do with the fact that the average bear market lasts much shorter than a boom. Just one year is enough to reduce portfolio size by 50%, as it did in 2008, and that’s only if we don’t use leverage. Otherwise, the losses could be much more severe. Also, keep in mind that the S&P index covers the entire spectrum of different companies, and even a simple correction can affect some sectors much more than others. You don’t have to go far to find examples. Since the beginning of this year, the SPY ETF in the S&P Index (blue line) has lost more than 13%. At the same time, the QQQ ETF on the Nasdaq 100 Index (orange line), consisting mostly of technology companies, is down 22%. However, the real loser was until recently the ultra-popular ARK Innovation ETF (white line), which has already lost more than 50%. Just a year ago, its constituent companies were considered “black horses” that, like Netflix or Facebook, would bring record price gains.

Since the collapse of COVID, the Fed’s surplus profits have been impressive, especially for the Nasdaq 100 Index. As usual, many novice investors assumed that if it rose, it would stay that way. A large number of them became fancy companies with all their capital and even with funds borrowed from a broker based on FOMO ( fear of missing out ). They didn’t want to pass up the opportunity to get rich quick. As studies show, this behavior mostly affects young people. This also explains why the correlation between tech stocks and bitcoins has been so high lately.

This is because cryptocurrency investors and fashion companies are the same group of people. Meanwhile, in the case of the Nasdaq index, 5 months was enough to make up for a significant portion of the 2-year gain.

If the decline continues this steep, we can expect a return to pre-pandemic levels by the end of this year. And here comes the headline question, “Why is the stock market falling so sharply?” Two reasons:

Greed vs. fear

The chart below illustrates in two words the relationship between greed and fear. The latter feeling is much stronger. Why is this happening? It’s all the fault of emotion, which shuts down rational thought in our brains and activates the primal instincts of fight or flight. When the first fluctuations arise, caused, for example, by rising interest rates or economic protectionism, investors’ emotions begin to change 180 degrees. Anxiety arises, which quickly turns to fear and despair. Because it is one thing to analyze in cold blood a 20% or 30% drop in quotations, and another thing to watch as we lose real money on the pullback. This is when stock indices lose the most, and we can feel it right now. Once stocks are at an extremely low level, the vast majority of investors are bordering on depression. According to the phrase “buy while the blood is flowing,” this is the best time to buy stocks, but not many people can do it, and even fewer have something to pay for.

Leverage

Another problem is the already mentioned leveraged positions, i.e. investing money borrowed from a broker. Leverage allows us to open positions with only a small amount of our own money. For example, if we have 100 Euros, we can buy stocks for 200 Euros or contracts for 1000 Euros or more. This means that just a slight fall in prices can rob us of all our capital, and even drive us into debt. If we use leverage, we have to have margin. If we can’t cover our losses from it, the broker calls us for a margin call (called a margin call ). However, many brokers nowadays don’t worry about this and automatically sell what we have. We are left with no cash and no assets.

Now imagine this situation:

Let’s assume for a moment that one of these Generation Z “prodigies” invested all of his and his mother’s money in the ARK ETF (which we showed earlier), and borrowed many times that much from a broker. After the first significant drops, the kid got his first margin call. Mom was making up for the losses. The young investor bought more ARK (after all, buying in the pit is key to investment success. Right?). As the stock plummeted after November 2021, another margin call followed. The genius went back to his mother and said: “Mom, Mom, I need more money because I fell victim to speculators, but now there’s an opportunity to make up for it.” Unfortunately, the mother could not afford further support, or maybe she was tired of her son’s greed. So he went to his father, and the latter decided that his son should finally get a job and not speculate with his money. And so the broker sold all of the young “investor’s” assets at a colossal loss.

From the point of view of one speculator it may seem ridiculous, but from the point of view of the whole market it is no longer so, and that explains why the stock market falls so sharply. This is about forcing the closing of very large positions. The kid in question, with the help of his parents, really could have bought maybe 100 shares of ETFs, but he had a position open for 200, maybe 1,000 shares. Now multiply that by a few hundred thousand, maybe even a few million such individuals, and we can see the magnitude of the problem. If we add to this the hedge funds, which are also willing to use leverage and invest in “what’s growing,” but have incomparably more capital, we can see what is actually causing the decline.

We must also remember that the situation is so bizarre that the availability of conventional credit is limited by creditworthiness. Banks don’t want to make real estate, car, or cash loans, seeing that someone can’t afford them. There is no such thing with brokers. You can only get really great funds to buy financial assets based on our balance with a broker.

So, can we use the level of leverage as an indicator of whether we’re at the peak of a bull market or the bottom of a bear market? Not entirely. No one knows how much leverage is being used today. There are different ways to borrow funds, different for individual investors, different for large organizations. Then there are derivatives, like options or direct market access (DMA) CFD funds, margin accounts, and many others. This is why Warren Buffett once called derivatives “financial weapons of mass destruction.

Margin Debt

Margin debt is the only reliable way to check the leverage of investors using US brokerage accounts. Keep in mind, however, that this indicator only covers popular U.S. margin accounts and nothing else. These types of accounts allow for little leverage, but are regularly monitored by FINRA (the US equivalent of the Polish KNF). Thus, we can conclude that margin debt is a fairly reliable measure of leverage.

Nominally, we can measure it in billions of dollars, adjusted for inflation (red line):

Unfortunately, such a measurement gives us little because the supply of currency that has hit the financial markets in the last decade has been enormous. In addition, the loss in purchasing power of the dollar is far greater than the official inflation rate indicates. The $100 is now worth only a fraction of what it was 20 years ago. So a better solution would be to adjust this figure for inflation, but express it in %.

However, this is not a perfect solution either, because such a comparison still does not answer the question of what our downside potential is. We are left with comparing marginal debt to GDP.

As we can see, however we measure it, the current level of leverage is at a very high level, even despite recent declines. At the peak of the boom in 2000, marginal debt was equivalent to 3% of U.S. GDP, as it was in 2008. Currently, we are still above that level, and we are still far from the bottom. During the bear market in 2000 and 2008, marginal debt declined by about 50%, and now (since October 2021) by about 17%. Thus, we see that the potential for further declines is still enormous. It is worth noting that during the panic over COVID, marginal debt relative to US GDP fell to 2.2%, which is still a high level compared to the bear market bottom of 2003 or 2009, when it reached 1.3%.

Summary

Should we be worried?

Yes, especially if we have used leverage to buy growth companies and other assets with high volatility. Any serious drop in prices could cause open positions to close, and there will be fewer and fewer people willing to buy assets on credit. First of all, almost nobody buys assets after or during a big drop. Second, the cost of servicing the amounts borrowed from a broker increases as the interest rate rises. Of course, we can assume that drops are not eternal and we will eventually recover, even if we made purchases at the very top. Of course we do, but how long will it take?

During the 2000 crash, the Nasdaq 100 Index lost over 80% and it took 15 years (!) to get back to its former peak.

Do we assume the same bear market as in 2000? No, but no one really knows where the bottom is and when we will reach it. If the battle with inflation continues and central banks continue to raise interest rates and tighten liquidity, indices may quickly lose whatever they have gained over the past two years.

A team of independent traders

PS. Are we totally against using leverage? Not necessarily. While it’s silly 99 out of 100 times today, you can use the difference in margin with inflation to your advantage in a safe and reasonably predictable way. A potential long-term average annual return of a dozen or so percent is now more than satisfactory.

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