Are markets still rational, even in a crash?

By PATRICK CAIRNS

March 2020 will be remembered as one of the most dramatic months in stock market history. The scale and speed of the global sell-off made it one of the most significant events that markets have ever seen.

At its lowest point, on 23 March, the FTSE 100 had fallen by 24% in just three weeks. Even though it recovered over the next few days, it still lost nearly 14% over the month.

This included a 10.9% drop in a single day on 12 March, which was the index’s second worst day on record. The 7.7% decline just a few days earlier, on 9 March, was the fifth worst when it happened, and is now the sixth.

A stampede

Such extreme movements on stock markets are often called irrational. After all, how can the value of a company – which is effectively what shares represent – change so dramatically in such a short space of time?

Shares in Royal Dutch Shell, the largest company in the FTSE 100 Index, fell by 36.6% in just 10 days. In other words, investors felt that by 16 March the company was only worth two thirds of what it had been worth on 6 March.

This is a company with a market capitalisation of over £100 billion, so a change this big means many billions of pounds of value disappeared in a matter of days. Superficially, it’s hard to see how this can be rational. After all, Shell still owned all of the same pipelines, projects and plans that it did at the start of the month.

What markets measure

There are, however, two important issues to take into consideration. The first is to appreciate that investors buy and sell shares based not so much on what a company’s operations are worth right now, as on what they are likely to be worth in the future.

So when the oil price crashes and large parts of the global economy are shut down due to Covid-19, Shell’s future profits are suddenly greatly reduced. The attraction of holding its shares will therefore fall too.

Even more significantly, however, is that in moments of extreme economic stress like the markets saw last month, investors value cash more than anything. They therefore sell liquid assets like shares in order to get the cash that they crave.

This means that they might not bother very much about what they are selling, or how much they are selling it for. They just want the cash.

So did index funds make it worse?

Inevitably in times like these, questions will also be asked about what made this crash particularly severe. Why did the fall happen so rapidly and on such a remarkable scale?

Some have pointed fingers at passive investing. Their accusation is that because index funds don’t discriminate between individual companies, investors are either just buying or selling everything. And in March, there was a lot of the latter going on.

However, this is an obviously flawed argument for three reasons.

The first is that there were a lot of investors of all types who were just selling whatever they could to get cash. In other words, broad-based selling wasn’t limited to index funds.

Secondly, even in the country with the highest concentration of passive investing, which is the USA, index funds only own around 25% of the value the entire stock market. Simple logic would suggest that one quarter of the market cannot dictate what happens to the other three quarters.

And thirdly, the selling of stocks was actually not indiscriminate. There were significant differences between how certain shares performed during the month.

Not all the same brush

As Dimitris Melas, global head of core equity research at MSCI, points out:

“We have seen a number of areas in the market that have actually out-performed,” he says. “If you look around the world, sectors like communication services, healthcare, and utilities – some of the defensive sectors that are less sensitive to the economic environment – have out-performed.”

Most strikingly, Amazon, which is the third largest stock in the S&P 500, actually finished the month up 3.5%. The index was down 12.5% for this period.

Microsoft, which is the largest company in the S&P 500, was down just 2.7%.

If index funds had played a significant role in what happened, these large companies would be the ones most affected. They are, after all, the biggest part of passive portfolios. The fact that they performed so differently to the market as a whole makes it fundamentally impossible for index funds to have been responsible.

It also suggests that the crash last month was perhaps not entirely irrational either.

“My observation so far is that markets have reacted quite rationally to this extreme economic shock,” Melas says. “When you have an economic shock of this magnitude, obviously economic activity slows down, and so the drawdown we have seen so far in global equities, which is around 25% or 30%, depending on where you measure it from, is actually quite a rational market reaction.”