What we had this week and late last week was a scare. It was a trip to your doctors rather than a trip to A&E! Or, in technical terms, it was a market correction rather than a significant change in the playing fields of the world’s financial markets. The bubble didn’t burst – at least not so far!
Why did it happen?
Corrections and market bubbles bursting are all down to human behaviour. In this case, it is the herd mentality playing out. This is where individuals copy the behaviour of larger groups. It creates an avalanche effect across the markets and picks up more and more momentum until it naturally exhausts itself. Obviously it also involves two further tenets of behavioural science: 1. Overreaction i.e. a reaction in a way that is greater than the events warrant 2. Confirmation bias; people are more attentive to new information that confirms their own pre-conceived ideas on a subject.
The market participants all knew that the world’s financial markets had entered what they perceived to be bubble territory, they just didn’t want to admit it. What these people were looking for was confirmatory information to cement their pre-conceived ideas. Once they have this, then large scale selling can take place. Once this takes hold, quite often there is an overreaction and it is the blind leading the blind in these instances. It becomes a game of poker. The question is now: When should I fold my hand? As more and more fold panic takes hold, they don’t want to be the last one left standing and the herd mentality kicks in. The saying ‘like rats leaving a sinking ship’ springs to mind.
So what caused the correction of August 21st to 25th?
The markets had already been spooked by the chaotic goings on with the Greek debt crisis during the months before. The long protracted settlement, which in the minds of the market still hasn’t been fully resolved, put a smokescreen over the rest of the world. While this was going on, quietly in the background, the Chinese stock markets were tumbling and global commodity prices were hitting their lows not seen in nearly a decade. Stock markets in China, like the Shanghai composite index, sunk 30% over July and August. Technically, a move greater than 20% signifies a rout. Meanwhile, other global stock markets like the S&P500, Nasdaq 100 in the States, the FTSE100 in the UK, the Nikkei 225 in Japan had been part of a massive bull run that had lasted several years and these markets were getting nosebleeds they were getting so high!
Then, suddenly, the Chinese government devalue the Yuan to try and boost dwindling exports and a struggling economy. This in itself, could quite easily create a trade war amongst other leading nations that would also need to try to stay competitive, but to compound this effect China has grown into a financial Goliath. It sucks in huge amounts of the world’s natural resources. Countries like Australia, Brazil and South Africa are almost joined to their hip. China’s success is their success. For example, more than 40% of the world’s Copper supply is sent to China annually. Other regional countries like South Korea and Singapore are heavily reliant on trade with China. Major countries in Europe are to some extent propped up by the Chinese success story and the USA is heavily invested in China.
So, when the realisation that the Chinese were struggling finally hit the rest of the world and they did the maths, it was like a slap in the face. A sharp sting that jolted the globe into action. The market had its confirmatory bias that it was looking for. All markets in the global economy are now pretty much related, so once the initial flight took place, the avalanche could roll and pick up speed and the charging herd brought the markets down with a thump. The S&P500 was down very quickly on the Monday, nearly 12%, other global markets, especially commodities, were off heavily and the Foreign Exchange (Forex) markets were a frenzy of activity. The globe was poised for a major rout and the next major financial crisis; one not seen since 2007/09 with the credit /housing market bubble bursting and the famous crash of 19th October 1987. The biggest one day down move in the markets’ history (S&P500 off 22.6%) was on the cards.
The storm passes?
Then overnight, it was like the storm had just vanished! In the US, the markets had pumped in billions of dollars to keep it from falling any further and at the time of writing, the correction down has almost disappeared. Oil that had hit rock bottom had gained 12% in 2 days. The bulls had silenced the bears! Things look like they have returned to normal – for the moment at least?
Not quite yet. There is still the problem in Greece and China is not out of the fire yet. What is going on in China quite closely resembles the Asian crisis of the late 1980’s and early 1990’s: corruption, business/government collusion, property and stock market bubbles, which Japan is still recovering from today. It was a crisis that almost nearly destroyed the world and brought the US down. The Chinese dragon has some housekeeping to do if it is to prevent a financial meltdown across the globe.