Doest marketeth spelleth doom? Forgive the Shakespearean wording that may come afoul. We appeal only to those not faint of heart and those that dare to charge and defend the market damsel in distress chivalrously. Alas, alas for the fairest of maidens! What to do in the time of stock market crash?
Drivers of stock price
Economic news such as industrial production, changes in the risk premium, the yield curve (e.g., Government Bond yield), and inflation influence stock returns (1,2). Central banks can influence stock prices, too: either by hiking interest rates to alter the behavior of consumers and businesses or by altering the exchange rate of currency (3). Human “less rational” things like herd behavior, payoff, reputational interactions, social learning, and informational cascades in capital markets also impact stock prices (4).
All this theory is fascinating but does not fully explain the recent S&P 500 index drops that can erode novice investors’ trust in the market forces. While bid-ask spread changes in brokerages can explain the short-term S&P 500 index (or stock price) fluctuations, deeper S&P 500 index dives can increase natural secretions (e.g., sweat) and heart rate or cause dyspnea in many.
Understanding the mechanisms that drive the market prices up will help keep one’s pants on in dire situations. And to understand, at least to some extent, why the S&P 500 index has long-term positive returns.
The mechanisms of market (in-)efficiency
“These are not your parents’ financial markets. A generation ago, the image of Wall Street was one of floor traders and stockbrokers, of opening bells and ticker symbols, titans of industry, and barbarians at the gate. These images reflected the prevailing view that stock markets stood at the center of the financial universe. In these times, the core tenants for the efficient market hypothesis (EMH) were constructed” (5). The EMH states that stock prices at any given time point reflect all the information available about the underlying asset. Recently, it was shown that stock markets have a time-varying efficiency (6).
Gilson and Kraakman’s framework proposed that several factors ensure fair pricing: securities fraud litigation, mandatory disclosure requirements, insider trading restrictions, and the actions of securities underwriters, venture capital firms, auditors, credit rating agencies, and other “reputational intermediaries.” Help the markets to stay efficient (5).
It would be wrong to say that every force on the market aims to make the market more efficient. The markets demand safe assets. This leads to the construction of “safe assets” that are sufficiently low-risk and opaque that holders readily accept at face value. Securitization structures have been proposed as such assets. Securitization structures repackage cash flows from debt instruments to produce new financial instruments that are less risky and more opaque than the underlying debt(7). The previous long sentence should be read as follows “do not trade complex financial instruments unless you understand them.” A similar notion was also discussed by Vernimmen et al. 2020, where they concluded that a convertible bond is often presented as a miracle product, with downside protection by virtue of its debt component and upside potential by virtue of its equity component. This product is a mirage because this instrument allows the issuance of bonds at an interest rate below its normal cost of debt, which will lead to the issuance of shares below the share value at a time in the future (otherwise, no conversion would occur). In such a fashion, current shareholders will be diluted on poor terms Vernimmen et al. 2020.
Shorting stocks makes markets more efficient
Financial derivatives are used for a number of purposes, including risk management, hedging, arbitrage between markets, and speculation. Derivatives are associated with numerous financial contracts, including widely used and analyzed futures, options, forward prices, credit default swaps, and mortgage-backed securities (8). Short selling keeps stocks, futures, options, swaps, and exchange-traded funds (ETF) priced at fair value.
Investors who sell short believe the stock price will decrease in value. If the price drops, one can buy the stock at a lower price and make a profit. Conversely, if the stock price rises and one buys it back later at a higher price, one will incur a loss. Short selling is for the experienced investor that seeks to weed out bad stocks from the market.
Inverse ETFs and infinite money
An inverse exchange-traded fund’s (ETF’s) price rises (or falls) when the price of its target asset falls (or rises). For example, an inverse ETF may be based on the S&P 500 index. Such ETFs are designed to rise as the index falls in value. Thus, if one believed that the stock market would definitely collapse, then it would be reasonable to go “all in” on such an ETF (e.g., ProShares UltraPro Short QQQ (SQQQ)) because, in case of a complete market collapse, such a fund could earn infinite money. However, investments in inverse ETF can only be made short-term (for example, day trading) and would probably be most appropriate for very experienced investors. Such a recommendation is very often formulated not because the markets do not want to allow the “simple people” to earn money but because long positions with inverse ETFs provide negative returns because the market indices usually bounce back.
Competitors can buy companies that are continuously undervalued to remedy the underpricing; thus, it is unlikely that the stock price of a good company will remain low long-term. However, there is no need to start suddenly buying stocks as soon as their stock price drops suddenly see the previous article.
Summary
Economic news changes stock prices. Short-term stock price fluctuations can be explained by bid-ask spread fluctuations (in the short term, the market acts like a voting machine).
Negative economic news like hikes in interest rates or company underperformance can decrease stock prices and this can appear as a stock market crash. However, the stock prices of most listed companies usually bounce back in the long run because various market players, auditors, and regulators weed out bad stocks.
Market players can short stocks to earn returns for weeding out bad stocks. The total collapse of the stock market is improbable. If a total collapse occurred, some types of institutions (e.g., inverse ETFs) would earn exorbitant returns. The stocks of such institutions are usually traded in the same stock market. It does, to some extent, shine new light on the Catch-22.
References
1. Chen NF, Roll R, Ross SA. Economic Forces and the Stock Market. Source: The Journal of Business [Internet]. 1986 [cited 2022 Dec 15];59(3):383–403. Available from: https://about.jstor.org/terms
2. Panetta F. The stability of the relation between the stock market and macroeconomic forces. Economic Notes. 2002;31(3):417–50.
3. Hsu AC, Utami F. Central Bank Intervention and Stock Market Response. International Journal of Business and Administrative Studies [Internet]. 2016 Oct 24 [cited 2022 Dec 15];2(5):151–61. Available from: https://ideas.repec.org/a/apa/ijbaas/2016p151-161.html
4. Hirshleifer D, Hong Teoh S. Herd behaviour and cascading in capital markets: A review and synthesis. European Financial Management. 2003;9(1):25–66.
5. Awrey D. The Mechanisms of Derivatives Market Efficiency. New York University Law Review [Internet]. 2016 [cited 2022 Dec 15];91. Available from: https://heinonline.org/HOL/Page?handle=hein.journals/nylr91&id=1137&div=35&collection=journals
6. Alves LGA, Sigaki HYD, Perc M, Ribeiro H v. Collective dynamics of stock market efficiency. Scientific Reports 2020 10:1 [Internet]. 2020 Dec 15 [cited 2022 Dec 15];10(1):1–10. Available from: https://www.nature.com/articles/s41598-020-78707-2
7. Judge K. The New Mechanisms of Market Inefficiency. SSRN Electronic Journal [Internet]. 2019 Oct 8 [cited 2022 Dec 15]; Available from: https://papers.ssrn.com/abstract=3462633
8. Chang CL, McAleer M. Econometric analysis of financial derivatives: An overview. J Econom. 2015 Aug 1;187(2):403–7.
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