What You Need to Know About the Ongoing Market Crashes 2018
On Monday, stock investors landed in the same boat as cryptocurrency investors—the boat that was sinking until yesterday. If you are at sixes and sevens, trying to figure out what has been happening and what you should be doing in case it happens again, then you’re in the right place.
Initially, the cryptocurrency crash was mistaken for a market rotation toward other asset classes. One hypothesis was that the crypto fever was over and investors were moving their money back into traditional investments.
As it turns out, that conjecture was in error. There was barely any substitution between cryptocurrencies and stocks because the stock market was likewise crashing. No, money was not flowing into safe-haven investments either, because gold prices were also tanking. It was doomsday everywhere.
So what exactly happened? Where was all the money going? Those are the questions I’ll try to address today.
Weighing the Cryptocurrency Crash Against the Stock Market Crash
No matter what financial theories may otherwise suggest, the gospel truth is that markets are largely driven by one factor, and that is investor sentiment. It is this element alone that brought upon us the two crashes.
In the case of the cryptocurrency crash, at least four significant bits of bad news in the past one month busted up investors’ bloated hubris. Here’s a quick rehash:
- Rumors of a cryptocurrency ban in South Korea.
- Major U.S. banks ending support for credit card-based cryptocurrency purchases.
- The Indian government’s crackdown on crypto exchanges.
- History’s biggest crypto heist—the CoinCheck hack, worth $500.0 million—raising questions about investment security.
Just as these events decimated crypto prices, a carnage began on the other side of the aisle. Stock markets likewise began to crash as the “fear index” hit record highs.
For reference, the CBOE Volatility Index—more commonly identified by the symbol “VIX”—is the barometer of investor sentiment used to gauge market fear. Every time it spikes, fear of a crash looms large. And this fear index jumped 100% in the past couple of days.
The last time the VIX rose this high was back in 2011 when U.S. debt lost its AAA credit rating. Prior to that, it surpassed this level through the 2007 crisis that sparked the Great Recession. So, this spike is no joke.
But why exactly were investors panicking?
A close guess is that markets got increasingly fearful of rising U.S. inflation, which may encourage the Federal Reserve to once again contract the U.S. economy by further raising interest rates. This will have a ripple effect across the U.S. markets, and ultimately the global markets.
So far, it remains uncertain whether the Fed would reconsider its next policy move following the crash. However, a lot of fuel was added to this fire on Monday as uncertainty peaked following the appointment of the new Fed Chief.
Jerome Powell replaced Janet Yellen as the new Fed Chairman on Monday only to watch the Dow Jones Industrial Index record its worst one-day drop in history. Clearly, markets were hinting that they’ll take their time to figure him out. Until then, the uncertainty will likely linger on.
So, you see why the markets crashed? It’s because pessimism was on the rise across the board. Now that we have context, it’s time to figure out where all the money was going.
By the end of Monday, bond prices picked up and yields began to drop. It became obvious that money was taking “flight to quality.” Bonds emerged as the only asset class in demand. Investors seemed to be moving out of risky investments (stocks and cryptos) and putting their money into bonds.
But mind you, the majority of these investors were quite possibly institutional investors—that is, fund managers adjusting client portfolios to account for risk exposure.
Many of the average retail investors likely watched from the sidelines. Some may have liquidated their investments into cash, others may have continued to hold on. We can’t be certain.
What’s certain, however, is that negativism spread across crypto and stock markets alike. And it is this sentiment that drove the sell-off. But wait, there may be more to this story than meets the eyes.
How to Survive the Cryptocurrency Crash
I stumbled upon an interesting post on Reddit yesterday, where the Redditor offered a unique take on the crash—a reasonable proposition that shows us the flip side of the coin. The gist of the post was that the crash was triggered by an “opinion flow” not “money flow.”
Here’s how this cryptocurrency crash can be understood. (Source: “I will tell you exactly what is going on here, this is critical information to understand if you are going to make money in this space. How prices work, and what moves them – and it’s not money invested/withdrawn.,” Reddit, February 5, 2018.)
Let’s say Bitcoin is trading at $10,000 apiece today. For some reason, if the market opinion of Bitcoin turns negative, potential buyers of Bitcoin will start pricing it lower. Seeing the dwindling buyer interest, sellers will begin to settle for the lower price. That’s basic economic theory.
Now, assume that the investor sentiment turns so negative overnight that by the next morning, new buyers are bidding only $8,000 for one BTC. But no sale has taken place so far, so this price is not yet reflected in the market price.
Cryptos can be bought in fractions, so a buyer looking to buy only $10.00 worth of Bitcoin at the lower rate gets matched with a seller willing to sell it. If the sale goes through, this lower price becomes Bitcoin’s new market price.
And just like that, Bitcoin’s market price crashes by 20% overnight, even though only $10.00 worth of purchase actually takes place.
Simply put, in the event that investor opinions shift against cryptos, the bid-ask spreads keep narrowing and subsequently dropping until a deal is closed. Even if only a fraction of the crypto is actually sold, this lower price becomes its market price.
If this makes sense to you, then you can sum it all up to conclude that perceptions and not fundamentals drove down the value of cryptocurrencies through this crash.
Nothing had fundamentally changed about your investment. The technology you invested in was still there. Real-world partnerships were continuing to be made. The next big project launch was still underway. Absolutely nothing about your cryptocurrency was affected by this market fear, except its price.
So it’s easy to get a hang of today’s recovery in the crypto markets. All it took was another turn of sentiments, which culminated after the U.S. regulators took a soft stance on cryptos in Tuesday’s cryptocurrency Senate hearing, and prices began to climb again. The rest is history.
The cryptocurrency crash and the stock market crash were both driven by pessimistic sentiments. The investor exuberance that inflated stock and crypto prices through the bull market temporarily went missing. But as soon as the dust settled and another flurry of good news made its way to investors, sentiments took another 180-degree turn.
At this point, investors must be warned that markets go through ups and downs. We can never rule out the possibility of another crash. Were it to happen again—and chances are that it will—just remember that a healthy dose of discipline with a dash of faith may be a great recipe to survive it.
Successful value investors treat these ephemeral crashes as lucky opportunities to stock up on their favorite investments.