Why did the stockmarket fall? Maybe it’s because it rose too far, too fast

Stockmarkets saw a big selloff yesterday, with the US Dow Jones index down by almost 7%. John Stepek asks: is this the start of another "big one"? Or just a breather?

I mentioned yesterday that markets might choose now to have a bit of a breather.

I may have understated things a little.

Yesterday markets took rather more than a breather. They suffered their single worst day sell-off since – well, since April – but those were scary times as we all know.

So what gives? And is it the start of something bigger?

Believe it or not, a drop in markets is not against the natural order

Markets took a big knock yesterday. The Dow Jones fell by nearly 7%, the S&P 500 fell by just under 6% and even the tech-heavy dynamo that is the Nasdaq ended the day lower. (I’m using the US markets because they are the biggest ones and tend to lead events, but for all of us UK investors, rest assured that the FTSE 100 and 250 had a rubbishy day too).

Anyway, that’s the damage report out of the way. Let’s get to today’s point.

Here's something that's always fascinated me about markets (I mean, there are a lot of things that fascinate me about markets, but let’s focus on one for now): markets are about price discovery; they’re meant to go up and down. It’s not all one-way traffic, otherwise we wouldn’t need them.

In a properly functioning market, the information we get from prices going down is just as valuable as the information we get when they go up. A commodity price has fallen? Hmm, maybe that means that there’s too much of it, so we should stop producing so much of it. A share price has fallen? Well maybe it means that this company’s prospects are deteriorating – maybe there’s a more dynamic rival out there that we should be investing in, or maybe the industry is in trouble?

So we all understand the theory. It’s not that hard.

Yet when prices fall, it’s always viewed as a straightforward “bad” thing. And increasingly, almost an aberration – something against nature. When prices fall hard, as they did yesterday, the question is always: “What’s wrong?” What occurred to make this happen? Has something broken? Did someone press the wrong button?

It’s very rare that anyone takes a look at what was going on ahead of the “mini-crash” and thinks: “Hmm… maybe folk were getting a bit excitable.”

I mean, we have just seen the fastest rally in market history. Perhaps markets were primed to let off a little bit of steam after that.

And the Nasdaq tech index did just hit a whopping great round number – the 10,000 mark – and even if you’re not a great believer in technical analysis, the reality is that people do put store in big round numbers. Was the year 2000 any different to 1998 or 2002? No, but we all felt it was more significant on New Year’s Eve. It’s just the way we’re built.

And there were signs that just a wee bit of irrational exuberance was creeping in. I mean, call me a fuddy-duddy, but the news that car rental group Hertz – which is literally bankrupt, in that it has filed for Chapter 11 bankruptcy protection – is considering issuing new shares in order to take advantage of its soaring share price, and thus pay off its debts, is… well, it’s unprecedented.

This is most likely to be a wobble, not a prelude to a crash

Throw into the mix that, on Wednesday night, we had an event that always leaves investors holding their breath – the Federal Reserve’s monetary policy decision – and you have a market that was ripe for some sort of correction.

The old adage “buy the rumour, sell the news” exists for a reason. The Fed was dovish enough (probably as dovish as it could be) but it would’ve been very hard for it to shock markets into going even higher. Jerome Powell took a while to come round, but now markets accept that he is even more Greenspan than Alan Greenspan ever was. He’ll do what he can to keep markets up.

Trouble is, now that they have faith in him, anything short of Powell literally printing money there and then to buy shares in any future Hertz rights issue was always going to mildly disappoint.

So, to cut a long story short – we had a market that had probably come too far too fast, and was always going to struggle for more reasons to keep going. We had a major technical barrier (that 10,000 Nasdaq) and we had a big event (the Fed meeting). On top of that, we had a sudden stab of panic about Covid-19 cases going up again.

It all adds up to the ideal place to knock a bit of froth off the top. And I suspect that’s what happened.

A wobbly few days to follow? Quite possibly. Another plunge to March’s lows? I suspect not. (I’m not saying that’s impossible, but I don’t think this is it).

We’ll find out soon, I’m sure. And as I’ve said before on numerous occasions, as long as you have a plan and you’re sticking to it, you shouldn’t have to worry about this short-term stuff anyway.

Oh, and make sure you subscribe to MoneyWeek magazine. My story about how inflation could take off and how to invest for it is in this week’s issue, which is out today. Get your first six issues free here.

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