Markets had a nasty day yesterday.
In the US, the S&P 500 wiped out its gains for 2014 so far, falling by 1.2%. Over in Asia, Japan took a hammering, as is its wont, falling about 3% overnight.
Why did the market fall so hard?
Well, take your pick…
Ukraine, China, the Fed – they’re all possibly to blame
There are lots of potential reasons behind yesterday’s market panic. The obvious one is Ukraine. The West and the Russians are getting increasingly shirty with one another in the lead up to a Russia-backed referendum in Crimea on Sunday.
Clearly there’s the worry of what this could escalate into. But another interesting point relates to how hard Russia’s markets have been hit by threats of sanctions. Financing deals in Russia are being delayed and, according to the FT, some over-leveraged oligarchs are already facing margin calls.
That’s what happens when you’ve used borrowed money to invest, and the underlying investment goes against you. It usually means that to maintain the position, you have to sell a more liquid asset elsewhere to raise money. So maybe part of the panic is driven by a need to raise cash on the part of various wealthy individuals.
So that’s one theory. Then there’s China. The big fear here – not to pull punches – is of a 2008-style credit crunch. China saw its first corporate default last week. Yesterday came news of another. Haixin Steel, a privately-owned but massive steel mill, has failed to repay its loans. That’s partly what drove the big drop in iron ore prices this week.
You can certainly see why this might panic people. China has lots of bad debt. And a lot of it is interlinked. As the FT reports, “steel traders fear Haixin is deeply entangled in triangular debts with coal suppliers and other local companies and that its inability to pay back loans to state banks could trigger a wave of defaults”.
Now I love a good credit crunch story as much as the next bear. And regardless of government assurances, these things do have a habit of spilling out of control. We’re dealing with people, after all.
If lots of Chinese people and companies and local governments have made bad investments on the basis that the government will always bail them out, then a reversal of that attitude could see problems crop up in all sorts of places. And I’ll be particularly interested to see what happens to all that copper and iron ore that’s been used as collateral to secure loans if prices keep tanking.
That said, China is sticking to its story that this is all part of the big game plan. China has too many steel plants. Part of its anti-pollution drive (see Matthew’s Money Morning from yesterday on this) is to get rid of the worst of them.
And if the Federal Reserve could convince a capitalist democracy like the US to nationalise its entire banking industry by the back door, then I don’t think China will have any qualms about stepping in to prevent any Lehman-style crunch. But it’s certainly something to keep an eye on.
On top of all this, over in the US, a key member of the Federal Reserve – Stanley Fischer, Janet Yellen’s deputy-to-be – didn’t sound like a man ready to stop tapering. “The exit [from emergency monetary policy] has begun,” was among his choice quotes.
So some of the more wishful-thinking investors out there might have got rattled by the reminder that monetary policy really is getting tighter.
When markets get expensive, they get vulnerable
So – lots of good reasons for markets to fall there.
Of course, this time last year I could have probably found you a similar number of good reasons. It’s the taper. It’s Syria. And the year before that, it was Greece (and the year before that, and the year before that).
I think all this really goes to illustrate is that when a market is pricing in an awful lot of good news, then any number of things can bring it down.
Volatility has been extremely low. The bull market has been going on for five years now – not the longest on record, but longer than average. And the US stock market – which like it or not, tugs the leash of every other stock market in the world – is very expensive on most sensible measures.
When markets are cheap, they can handle a lot of bad news. When they are expensive, just about anything can knock them off their stride.
It boils back down to those golden rules we were talking about the other day: buy stuff when it’s cheap, and rebalance your portfolio regularly (though not frequently) to make sure you’re taking profits when you’re making them and topping up when prices fall.
For more on rebalancing, MoneyWeek subscribers can have a read at my colleague Phil Oakley’s piece on the topic from earlier this year. If you’re not already a subscriber, you can get your first three issues free here.
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