PRAIRIE VIEW, Texas (April 10, 2020) – Along with markets in much of the industrialized world, the U.S. stock market crashed in March 2020 as the fast-moving COVID-19 pandemic engulfed the nation. By this time, the deadly virus, against which no known vaccine existed, had proliferated to more than a hundred countries in virtually every continent, infecting nearly half a million people.
With the benefit of hindsight, it seems the U.S. stock market was slow in recognizing the rapidly growing global health crisis with potentially catastrophic implications for the U.S. economy. The earliest case of the novel virus originating in Wuhan, China, became widely known in the global media in January. However, the U.S. stock market continued to rise until Feb. 12, the day the market, as measured by the Dow Jones Industrial Average (the Dow) peaked at 29,551. This was at the tail end of a bull market that lasted 11 years, the longest in modern history.
From the Feb. 12 peak to the close of trading March 9, the Dow lost nearly 20% (5,900 points) of its value in four weeks. On Monday, March 9, the Dow tumbled 2,013 points, or nearly 8%, a record-breaking event. Measured in points, this was the worst one-day drop in the Dow’s history! However, the worst was yet to come. On Thursday, March 12, the day after the World Health Organization (WHO) officially declared COVID-19 a pandemic, the Dow lost a jaw-dropping 2,352 points, a 10% drop another record-setting event. By now, it was clear the market was hurtling towards something more than a “correction,” which is defined as a 10% decline.
There were strong indications we were witnessing the beginnings of a “bear market.” The extreme volatility continued, getting worse by the day. On Monday, March 16, the Dow plummeted by an astonishing 2,997 points (12.93%) – not only was this the largest one-day point decline, but also this collapse was a bigger percentage drop than the 12.8% decline on the infamous Black Monday in 1929, nearly 90 years ago, marked by historians as the day the Great Depression began.
Why should one be concerned about a decline in the stock market? This is a big concern for several reasons. First, the stock market plays an important role in a capitalist economy by connecting the saver with the investor. Entrepreneurs and companies that wish to expand their business find a ready source of capital in the stock market, which helps them avoid debt. This critical source of capital and finance is impaired in volatile or declining markets.
Second, there is a direct connection between the stock market (or Wall Street) and the real economy (or Main Street). Economists who study business cycles consider the stock market a barometer and lead indicator for future movements in the real economy, or growth in gross domestic product (GDP). A steep decline in stock prices is early warning of potential trouble for the real economy. A precipitous decline indicates that investors fear disastrous consequences for the real economy, in this case, from the pandemic.
Last, but not least, a declining stock market wipes out significant savings and wealth in the economy. This negative wealth shock has the potential to reduce consumer spending as people lose confidence in the future of the economy and increase their saving for a rainy day. The combination of real and psychological effects from major declines in stocks can be devastating for the real economy.
Why did the stock market lose so much value in March 2020 in such rapid succession? Economic historians will write about this for a long time. Doctoral students will write dissertations on this, given the abundance of big data available on this modern economic event. However, even at this early point, one can point to a number of factors that might have contributed to this massive decline in stocks, along with extreme volatility.
One theory is that the market was ready for a correction after a very long bull market. At this late stage in the 11-year bull market, the valuations had become unrealistic as speculative elements dominated. Media coverage of stock prices making new highs attracts less-sophisticated investors lured by the promise of easy money. This might have led to what economists call a speculative bubble, when market prices reflect speculative forces more than real fundamentals. Take the example of Tesla, Elon Musk’s company, which produces a high-quality electric vehicle with high brand recognition. After a long slump due to production issues, the company ramped up production of vehicles, and Tesla’s stock price jumped 143% to $917 over an eight-week buying frenzy. On Jan. 8, the stock rose 5%, valuing the company at $89 billion, larger than the combined value of GM and Ford.
When investors believe a stock price will jump the next day, they rush in hordes to buy the stock, which boosts demand for the stock. These self-fulfilling expectations can take place in the market for any asset or commodity and leads to what economists call a speculative bubble, where crowd psychology plays a more important role than the fundamentals of the company.
As the bubble inflates, it inevitably pops, since the growth is unsustainable. Only the needle or the trigger is missing for the crash in its price.
A second factor behind the March 2020 crash is likely the very real global pandemic from the spread of COVID-19. Once the virus spread out of China, it was too late to localize the damage. Too many world leaders were negligent and caught unprepared for crisis without precedence in recent world history. Public health experts understood the grave threat of a virus, but politicians with a short horizon ignored their warnings. Given the lack of credible leadership and response, the potential became real for the virus to spread unchecked, causing massive death and dislocation. The only real solution was large-scale testing, universal social distancing and self-quarantining, strategies which could lead to the demise for many markets and industries which exist and thrive on human physical interaction.
The investors panicked and started selling expecting a big decline in GDP, an imminent recession and an inevitable depression. As in any bubble scenario, once the decline begins, the amateur investors are caught unprepared, ensuing in a mad rush to the exits, making the decline faster and more severe than otherwise justified. The algorithm-based trading on Wall Street likely accentuated the selling, adding to the speed of the crash. The stock market bubble initially popped, perhaps on March 9, with the largest one-day point decline in the Dow’s history to that day (the Dow fell 2,352 points March 12 and 2,997 points March 16).
How does the future of the equity markets look from this point? Given the poor leadership shown by the current administration in seeking a science-based collective response, and the inability to respond with sufficient urgency to increase the supply of masks, testing kits, and ventilators, the prognosis for the economy is not good. Every crisis is different. The nature of this crisis – fast-moving infectious virus, which leads to respiratory complications for some, relatively high mortality rates, a lack of hospital equipment, and the necessity for social distancing and quarantining large chunks of the population and the economy – bodes ill for a market economy that thrives on social interaction.
A recession with a huge spike in unemployment is already upon us. Whether this would lead to a deep and long depression depends on how much havoc the virus causes to the productivity in the economy, and how resilient and creative the businesses are in responding to the new realities. Goldman Sachs economists have predicted an annualized contraction in GDP growth of negative 6% in the first quarter, followed by a jaw-dropping negative 24% in the second quarter, before the economy makes a recovery. These are mind-boggling numbers, given that the economy was in relatively good shape, with a 50-year low unemployment rate, with low but steady GDP growth, and low inflation and interest rates.
How will this economic scenario affect the ordinary American? For Americans who have significant investments in the stock market, either directly or through their pension 401(k) funds, the past few weeks must have been disorienting and perhaps nerve-wracking. The U.S. stock market has been whiplashed with unprecedented volatility. Nearly every day, the market has recorded historic moves and sometimes head-spinning intraday reversals. Losing 20% to 30% of one’s lifetime savings in a few weeks can lead to panic moves by many investors, and certainly sleepless nights.
Severe as this stock market decline has been, compared with earlier corrections and bear markets, the overall decline is within the historical ballpark. For example, in the 2008 market meltdown, stocks reached an intraday low of over 50% before recovering. The stock market experienced equally steep reductions during the Great Depression of the 1930s.
How should one respond to protect one’s savings and investments? Most financial advisers will suggest that one should not panic and sell stocks in a down market, because over the long run, the markets have always bounced. Of all assets, stocks have the best track record for long-term returns.
Munir Quddus, Ph.D.
However, what might be true for a young investor 20 years away from retirement might not be the case for someone looking at retirement in five years. For the latter group, the best strategy is to move their portfolio toward capital preservation from a growth portfolio. Ideally, one implements this strategy in a gradual, sustained manner when markets are calm, and not abruptly when the markets are volatile.
For those who invest directly, using “stop loss” orders, avoiding borrowing funds by using margin, and using instruments to hedge are all sensible strategies to safeguard one’s capital from steep declines. Remember that panic-buying and panic-selling can both be costly. Professionals also advise those who have disposable income to continue investing in stocks, carefully choosing companies and sectors that are depression-resistant and that will rebound quickly when the economic picture brightens.
Munir Quddus teaches economics and serves as the dean of the College of Business at Prairie View A&M University.