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Investment Insights, Inc.

What Happened? That Was Really Fast!

The drop in both the stock market and the economy was breathtaking, and not in a good way.  This is the kind of thing we prefer to read about in history books, but not actually experience!

From February 19th to March 23rd the S&P 500 index fell from 3393 to 2191 – a drop of 35% in less than a month. 

By the time you read this, we will have a pretty good idea how bad the economy was hit, but even before the official numbers, we know it’s been historically bad. 

Yes, of course, we know what happened.  We were hit by a pandemic.  But it’s very useful to understand what happened in the stock market during this historic collapse. 

The stock market is, by any measure, huge.  The total value of the market as of the end of 2019 was $28 Trillion.  You and I didn’t move the market.  This was major money.  Who was doing all that panicked selling?  Is it people that know more than you and me? 

Let’s assume that most of the people that get to manage very large pools of money are smart people with access to many other smart people.  But I don’t think that what went on during this collapse is because the sellers are smarter than we are. 

Actually, what I’m about to describe seems pretty dumb, but that’s just my opinion. 

Over the course of the last two years, investors had grown increasingly comfortable with risk.  As a result the amount of money borrowed against stock holdings, known as margin, had reached record high levels. 

The amount of money that you can borrow against stock holdings is limited by regulation to 50% of the value of the stocks.  Most investors do not use margin.  This includes average everyday people as well as large institutions like pension funds and most mutual funds.  Retirement funds are prohibited from using margin and many large institutions are restricted from using margin by their charters. 

But hedge funds face no such restrictions and often use margin.  Hedge funds, as a class, charge among the highest fees for investment management.  If they make outsized returns, the fees can be justified.  But often those outsized returns are a result of using margin.  If I buy a stock for $10 and it goes up to $15, I have made 50% return.  But if I buy a stock for $10 by using $5 of my own money and borrowing the other $5 on margin, then if the stock goes up to $15, I will have made 100% return, less the interest on the money I borrowed. 

As the stock market relentlessly pushed higher the returns of some hedge funds that used margin looked very good.  Good enough, in the minds of many investors, to more than justify the very high fees these funds might charge. 

It was a great party as long as nothing went wrong.  There’s a wonderfully colorful Warren Buffet quote that comes to mind.  “When the tide goes out we find out who wasn’t wearing a bathing suit.”
When the market was going up, margin amplified returns.  But when the tide went out, margin amplified losses.  And a cascade of selling started. 

Let’s go back to the $10 stock.   If you borrowed $5 against it, and the stock starts dropping, bad things can happen.  There’s some very technical rules about this, but for the sake of example, I’ll keep it simple. 

If the stock drops below $5 in value, you now have less collateral for the loan than the amount you borrowed.  So, for example, if the stock drops to $3 in value, your loan will be called.  You have to pay back the $5, plus interest.  But let’s leave the interest out for the moment.  You now have a $3 stock that you owe $5 on.  Typically you would sell the stock and pay the additional $2. 

And now we get to where things got really crazy.  Because if you are running a large hedge fund and your loans get called (known as a margin call) you probably don’t have enough cash to cover the loans. So you not only have to sell the stocks that fell enough to trigger your margin call, but you have to sell things that still have enough value in them for you to meet your margin call. 

This is what we saw between February 19th and March 23rd.  Everything was being sold.  Stocks, bonds, gold, US Treasuries, everything because very large pools of money, most likely hedge funds, that had big margin calls, were selling everything that had value to meet their margin calls. 
But this doesn’t fully explain what happened. 

For every seller there must be a buyer.  What happens when there are no buyers? 

I know that for the last year or so prior to the collapse, I was having a hard time finding things to buy at what I consider to be attractive prices.  I also am certain I was far from the only person having that experience. 

And when things started falling, initially my view as that they had only fallen from over priced to fairly priced, but not to bargain levels.  So in the first week or two, I wasn’t very interested in the new lower prices.  And it seems I was far from the only one, because there still wasn’t enough buying to satisfy all the selling.  As the selling continued, I sat and watched.  Prices might be cheaper tomorrow.  This was a panic and in a panic, it’s very hard to know when it will be over and how far it will run.

But in the middle of all of this I spoke with a bond trader about a particular bond that might have been of interest and he said, “There’s no buyers.  We don’t know how far this will drop.  Wait until we start to see some buying.”

I think a lot of this is because so many of us lived through the financial crisis.  It’s recent memory.  Clear a lot of buyers were, like me, just letting things fall. 

If someone is being forced to sell to meet a margin call, and there are no buyers, then the seller has to keep lowering the price until they can attract buyers.  And in a market worth tens of trillions of dollars, this was happening on a massive scale.
So now you know some of what happened in February and March but how does that help now?  It helps because it strongly suggests what’s not likely to happen now.  All the large margin calls have been met by massive selling.  If a panic is to happen again – another leg down as many have suggested – it’s hard to see how it could happen the same way.  The large leveraged pools of money have been cleaned out.  At least a lot of them.  Panicked margin selling seems the least likely thing to happen now.

I would also suggest that bad economic news isn’t likely to send the market lower in the short term because everyone knows the news is going to be bad.  Even though we don’t have all the bad news yet, it’s as if everything bad is already old news because it’s so widely expected.  And that means it no longer has the same power to effect the market that it did at the beginning of all of this.

Ironically, all this damage means that where stocks were a bit high priced before, they are now more reasonably priced.  Expected returns from a reasonably priced market would be higher than from a high priced market.  In March, the market was a bargain.  If by the time this article is published, prices come back down near the March lows, I will be very interested.

There’s going to be some disappointment and maybe that will give a second chance to buy at those levels. 

I’ll end with this, “Never let a good crisis go to waste.”  Sir Winston Churchill

Hal Masover is a Chartered Rerement Planning Counselor and a registered representave. His ?rm, Investment Insights, Inc is at 508 N 2nd Street, Suite 203, Fair?eld, IA 52556. Securies o?ered through, Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representave, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Investment Insights, Inc & Cambridge are not a?liated. Comments and quesons can be sent to These are the opinions of Hal Masover and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.

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