As we just completed the December meeting of the Federal Reserve, the continued market sell-off accelerated. This was following the previous week’s European Summit, which was supposed to alleviate concerns about the eurozone. Neither the Fed nor the summit in Europe changed the market view that the situation is in crisis mode.
Many investors are left scratching their heads wondering how can all of the different investment sectors—stocks, oil, gold and so on—act the same in a market sell-off? The reason is that market participants, the big players, have become global behemoths. There is rarely a fund that doesn’t have its hands in international waters. This also applies to banks, which have gone beyond what most people think a bank does by just taking deposits and lending money. Now that same bank will take deposits and then leverage those assets into international investments to increase its rate of return.
Sounds great, so what’s the problem? A chain is as strong as its weakest link. Once that link breaks, the dominoes fall. If you’re a bank or fund with international investments due to a market view, you need to keep your books balanced. They’re supposed to do this by marking their portfolio with the current prices they can get if they liquidated their assets.
There are several issues with this inter-connected system. The first: it’s hard and almost impossible to know what price you can get for an asset if everyone else who holds that investment also wants to sell at the same time. The next problem: if one or more of your investments is going down in a market sell-off and you are over-leveraged, this will result in a margin call. This means either you sell your losing position, or raise money from selling another asset to put into the first trade. Either way, this creates more downward pressure on the entire system, regardless of your market view.
As more investments are tied together by global players, once one area starts crashing, it will force the funds and banks to sell off other assets. This creates a united market sell-off. This is how an avalanche starts. Everything is peaceful on the mountain when an event triggers snow to dislodge and start falling on other snow and ice, which continues in the same way until the slope flattens and it hits the bottom. Even though the snowflake on the top of the mountain is separate and different from one in the middle, they are connected.
In this sort of a situation, the market view may differ greatly from reality. Logic is frequently absent during a market sell-off. While scary, this also offers opportunities. Eventually, the avalanche is done and the mountain is peaceful yet again. Once the market view has deteriorated to such an extent that it’s overly pessimistic and devoid of rationality because of investors who are forced to sell from margin calls and who are desperate for cash, this is the time to step in and buy for the long term.