Stock Markets in Turmoil: What the Heck Is Going On?
The following is an effort to provide some background information to help teachers explain to students what is happening in the stock markets. We hope you find it useful. Some teachers may wish to share it with students as a background reading. Note that this was written on Tuesday the 23rd of January, 2008. By the time you read this, things may have changed quite a bit. That is the nature of stock markets – and it is why investors should only invest in stocks if they know what they are doing – or have good advice. We would welcome your comments and feedback. Gary Rabbior, President, Canadian Foundation for Economic Education, January 23, 2008 TSE falls 11% in one week Over the last week or so, stocks markets have turned very volatile. The Toronto Stock Exchange (S&P/TSX) lost about 900 points last week – and then over 600 points on Monday, January 21. With the stock market index sitting at around 13,600 last week, that represents a decline of about 11% (900 + 600 = 1500/13,600 x 100). That is a significant decline. Central banks try to help By Tuesday, at the time of writing this, the S&P/TSX has recovered over 500 points since the Bank of Canada and the U.S. Federal Reserve announced interest rate reductions of .25 per cent and .75 per cent respectively. It’s all over the news – Is the sky really falling? But this morning, the news headlines referred to “panic selling,” “markets plummeting,” “economies slumping,” and so on. With all these numbers flying around and headlines screaming like the world may be coming to an end, the average person may be wondering “What the heck is going on?” Let’s see if we can help bring a little understanding to the situation. What’s an index? First of all, a stock market index indicates what, in general, is happening to the prices of a selected group of stocks. If the prices of some of the selected stocks fall more than the prices of others rise, the index will fall – reflecting that, in general, stock prices (of the companies being monitored) are falling. In most recent times, the stock prices of many if not most of the companies monitored by an index such as the TSX have been falling – in some cases falling quite a bit, leading to large drops in the index. More people wanting to sell stocks than buy stocks = declining prices and a declining index Large declines in an index, such as we have been seeing, reflect the fact that many more people are looking to sell stocks rather than buy them – and for a sale to take place, the price in the market has to fall. The seller may have to willing to accept a lower price – and the buyer may have to be willing to pay a higher price for the deal to happen. In recent times, there has been much more pressure on sellers to lower their price for stock sales to occur. But what has prompted so many people to want to sell, rather than buy, stocks? Let’s look at a series of events and circumstances that have led to this.
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The Background – Setting the Stage for the Current Volatility
Things have been pretty good for investors First, stock prices, in general, have done well in recent years. The global economy has also been doing pretty well. The U.S. economy was growing, Europe’s economy was growing, and the economies of countries like China and India were expanding at quite a significant rate. When economies are growing, the demand for goods and services goes up, companies sell more, profits rise, and prices – including stock prices – tend to rise along with them. Commodity prices have been rising – which has been good for many Canadian companies Canada is fortunate to have many of the resources that companies around the world need for production. As the prices of those commodities (such as oil, copper, nickel, gold, and potash) have risen, Canadian companies have been doing quite well. So have some other industry groups, such as the banks. As Canadian companies have done well, they have attracted investors anticipating that these companies will continue to grow and increase their profits. The buying by investors of the stock of these companies pushes up the stock prices. Many Canadian companies have been attractive to investors – and, in some cases, buyers At the same time, some Canadian companies have been so attractive that they have drawn the attention of foreign investors, and some very major Canadian companies have been sold over recent years. The inflow of money to buy the goods we sell (our exports), to invest in Canadian companies, and, in some cases to buy Canadian companies (note that money has also flowed out of Canada as some Canadian companies have invested in, or bought, companies outside of Canada) has helped to push up the value of the Canadian dollar. Why? Because you need to buy Canadian dollars if you want to buy something from Canada, invest here, or take over a Canadian company. As more and more people want to buy the Canadian dollar, its value increases. Signs of weakness in the U.S. economy While this has been going on, the U.S. economy has been showing some weakness. The slowdown in the economy along with a high U.S. trade deficit (that is, the United States is buying more from other countries than it is selling to other countries) have led to a weakening U.S. dollar. A strengthening Canadian dollar and a weakening U.S. dollar meant that the Canadian dollar rose rapidly in terms of its exchange rate with the U.S. dollar, rising to about US$1.10 before Christmas. It has now fallen back to below US$1.00, but it is still relatively high in comparison to where it has been over the last many years. A rising Canadian dollar puts pressure on some Canadian companies So although many Canadian companies were doing well by selling commodities to a growing global economy looking for resources, other companies, such as our manufacturers, struggled. Why? Because as the value of the Canadian dollar rises in terms of the U.S. dollar, Americans who want to buy our exports have to use more of their U.S. dollars to do so. We sell much of our exported manufactured goods to the United States, so that is why a higher valued Canadian dollar makes it more challenging for our manufacturers – for example, our auto industry manufacturers who export much of their output to the United States.
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The recent scenario So to summarize the recent scenario: Many Canadian companies were doing well selling resources to a growing global economy. The prices of those commodities were rising, pushing up profits for Canadian companies and attracting investors and, in some cases, buyers. The stock prices of many Canadian companies were rising as a result. Increased flows of investment into Canada, high exports sales, higher interest rates – and a little speculation thrown in – all led to a rise in the Canadian dollar. This meant that although many Canadian companies did well, others (such as many manufacturers) struggled.
Prospects still looked good For investors, the world was still looking pretty good. And many forecasts said that things would stay that way. So investors kept investing in stocks, prices kept rising, stock indices rose, and most people holding investments had smiles on their faces. This was true in most markets around the world. With such countries as China, Russia, India, and Europe all showing fairly healthy growth rates, the prospects for investors looked quite rosy. But then things started to change – and it started with “sub-prime mortgage lending” Then things started to change. And it started, mostly, with the sub-prime mortgage lending in the United States. This, in and of itself, is not an easy thing to understand, but let’s give it a whirl. Sub-prime lending does not refer to the prime rate of interest as one might think. Rather, it refers to the borrower. A borrower is considered sub-prime when there is a higher risk for a lender. A sub-prime borrower usually cannot get credit from more usual sources such as a bank and must go to another lender where the rate of interest charged is likely to be higher because of the higher risk that the lender may not be paid back. Sub-prime mortgages Sub-prime lending has grown dramatically in recent years in the United States, especially in mortgage lending. Individuals with lower credit ratings looking to borrow money to buy houses found that money was quite readily available, although at higher rates of interest. As a result, more and more Americans bought houses to the point where 69 per cent of American households owned their own home. Maybe it seemed like a good idea at the time, but ... The lenders providing sub-prime loans were not closely regulated. Often they didn’t thoroughly investigate a borrower’s income level or the ability to pay back the loan. Why so lax? The loans were to buy a house, an asset that has value. If the borrower couldn’t make the mortgage payments, after a reasonable amount of time the borrower could sell the house to get the money to repay the loan or the lender could foreclose on the property and sell the house to retrieve the funds.
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As long as house prices held steady or continued to rise, the lender was pretty well protected. But what if housing prices fell? That was a completely different story. And that is just what happened. The “housing bubble” in the United States burst, and prices that had risen very quickly began to fall. When housing prices fall, the lenders who were counting on the value of the house to protect the loan can find themselves in difficulty. The idea spread – as did the risk In the sub-prime lending market, the lenders would package up these sub-prime mortgages and sell the debt to mutual funds, hedge funds, equity funds, and so forth. These institutions would then, in turn, often sell them to pension funds and insurance companies and other large institutions. The attraction was that the “packages of debt” provided an attractive return. By packaging and reselling these mortgages the problem spread. It started with smaller mortgage-lending operations in the United States packaging up the debt and selling it at a discount to bigger financial institutions who may have sold it to others, who may have sold it to others – and so on. These riskier loans got spread around the world. And, as they got spread around, there were more and more institutions holding this risky debt. Nevertheless, the situation may have been much less significant if housing prices hadn’t started to fall – and, in some cases, fall quite dramatically, in the United States. Things started to unravel So, all was not as it seemed. Many home buyers had borrowed money not really understanding the situation they were getting into and what would happen if house prices fell or if their mortgage payments should increase when they had to renew their mortgage. One of the things that has made the problem worse is that many of these sub-prime loans were “teasers” – offering low payments in the beginning and making it easy to get started – but then rising later – sometimes by quite a bit – making it hard for the buyer to keep up the payments. Lately, those “teasers” have started to expire, and borrowers have had to increase their payments – often on a house that is now worth less. Another factor was that many people were now taking out 30-year mortgages and putting little money down when they bought a house. This meant that buyers often had little “equity” in their homes. As a result, they were more willing to walk away when they couldn’t afford the mortgage payments. Another factor adding to the problem was that, in many cases, the estimated value of the house at the time it was purchased was above its real, actual market value. And other problems existed as well, such as rising unemployment that made it harder for some people to pay their mortgages when they lost their jobs. In short, there was the potential for things becoming a real mess – and that’s what happened. Then they got worse As interest rates rose in the United States, and as more and more people had trouble making their mortgage payments, more and more people starting defaulting on their mortgage loans. As a result, many homes were being listed on the market and housing prices fell. As this happened, lenders foreclosed on more and more mortgages, and house values fell even further. The result was that many of the companies that had purchased the debt, primarily mortgage-backed securities, found that they were not getting their
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money back. This included some major companies in the United States, some of which faced or had to declare bankruptcy. Investors became cautious – and credit got more scarce The impact of this was that investors in general became very nervous. Many were not sure whether or not their investments in mutual funds, pension funds, etc. contained these lower rated mortgage-backed securities, a term now heard frequently in the media. Many investors who thought they had put their money in relatively safe investments were now concerned that maybe their investments were not as safe as they believed. So many investors started looking to put their money in the safest investments they could find, such as government bonds and treasury bills. The central banks tried to help This led to the current “credit crunch” caused by the unwillingness of investors to put their funds into such investments. In an effort to help, some central banks used large quantities of their reserves to try to put money back into the system. The U.S. Federal Reserve also cut interest rates to try to make it easier for people to borrow or pay back their debts. But things continued to get worse. Then the real picture started to show itself As a result of the problems in the sub-prime lending market, many companies started revealing their “exposure” to these markets and the mortgage-backed securities – that is, the amount of money they invested (loaned out) that they may well never get back. As a result, they started writing down their exposure as assumed losses, and some of them were huge – $10 billion, $14 billion, and more. This started to attract the world’s attention. Hmmmm.... people started to get concerned – everywhere Around the world, people started wondering how this could occur without doing damage to the U.S. economy. People were losing their homes (which meant a lot of Americans were now feeling much poorer). Financial institutions that had bought the packages of debt had to begin writing off huge losses – that is, taking money off their books that they previously thought they would get but now wouldn’t. Investors started to worry as news of these write-downs spread. It became more widely known that financial markets were experiencing a “credit crunch.” Investors wondered how this would affect consumer spending, lending and investing, company profits, production and output? Could the U.S. hang in there? But there was still hope that the U.S. economy could hang in there. The fear, though, was that the United States would go into recession. When the value of a nation’s production of goods and services declines, rather than increases, for two three-month periods in a row, an economy is said to be in, what is now commonly called, a recession. And the concern about a recession in the United States is that Americans would then buy less, which would lead to a slump in global production and global markets.
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The President tried to help The President and others tried to put on a brave face and said that the U.S. “fundamentals” were sound and that the U.S. economy was healthy and unlikely to slow significantly. Even if it did, they assured the world, it was unlikely to go into recession. But then more of the reality began to be revealed Global investors were sceptical but hung in there. But then the write-offs started to get larger, and there were more of them. And people started to suggest that there was likely much more bad news to come. The problem was, no one was sure how bad it was going to get – and investors tend to hate uncertainty. Some started to sell, and many stock prices started to take some significant hits in the early part of this year. But maybe, just maybe, “decoupling” had become a reality But there was also some hope in global markets this time, even if the United States went into recession, there may have been a “decoupling” of the global economy from the U.S. economy – that is, the health of the global economy may not be so dependent on the health of the U.S. economy. Some began to think that the global economy would be able to weather the “U.S. recession storm.” The President and the Chairman of the Federal Reserve tried to help Then things started to look worse. The possibility of a U.S. recession started to rise. Global markets became more concerned and skittish. Pressures mounted for the U.S. to try to avoid a recession. President George Bush and Federal Reserve Chairman Ben Bernanke shared the concern and announced plans for a temporary injection of $145 billion dollars to boost spending in the United States – and the economy. But if the President is concerned, shouldn’t I (the investor) be concerned? The problem was that this injection of funds confirmed for the rest of the world that the U.S. President and Federal Reserve Chairman were worried. This led investors to believe that they, too, had cause for concern. When $145 billion isn’t enough – that is a concern The trouble was, with so much uncertainty and no one knowing how bad the sub-prime mess would end up being, global investors couldn’t tell if $145 billion would be enough. The plan seemed vague. It also appeared as though it was going to take some time to be implemented since it had to go through Congress. In the end, as events over the next few days would show, global investors decided it wasn’t enough. Those who were concerned became more concerned. Those who thought the world could withstand a U.S. recession became less sure. And all those investors who had made quite a bit of money from the stock market in recent years decided that maybe it was time to get out and grab the gains they had made. And the selling started. The fears were unleashed And then the selling spread from concerned investors in the United States to investors around the world. Many who had been wondering if they should sell, but had been hanging in there, scrambled to sell and get their money out of the stock markets.
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And down went the markets And so it went. Selling and fear spread throughout global markets. Europe declined. Japan declined. Australia declined. China declined. They even had to halt trading at the exchange in India for a while for fear that panic selling had set in. The Federal Reserve Chairman tries to help again In response, and prior to the New York stock market opening after the holiday on Tuesday, January 22, the Federal Reserve Chairman took the extraordinary step of announcing an interest rate reduction of three-quarters of one per cent. This was an attempt to calm the markets and to indicate that efforts would be made, in addition to the $145 billion in new spending, to keep the U.S. economy out of recession. But will it be enough? But there are a number of questions. Will the $145 billion be enough? Will the interest rate reduction help? Where is the U.S. economy actually heading? How bad is the sub-prime lending mess? How many more write-downs will there be – and how big will they be? Will consumers in the U.S. cut their spending? Will the U.S. economy head into recession – or is it already in recession? If so, will this lead to a global slowdown? Who knows? Is the worst over? Is it a time to buy? Only time will tell. And investors around the world will be trying to figure that out – and will be making their decisions accordingly. Investors face a dilemma, though. Once prices have dropped as much as they have, selling now means you “lock in your loss” if you sell when prices are low. That is, if prices should turn around and go up, you will not get that gain because you will have sold the stock. Other investors may feel that the significantly lower stock prices provide opportunities to buy the stock of good companies – ones that have a good prospect for the stock price to rise – perhaps quite a bit – in the months ahead. These different perspectives may mean that some investors may stop selling (fearful of locking in their losses) and some may start buying (looking for bargains). If that happens enough, global markets may level out and even start to rise. It may even be that, by the time you read this, stocks will have regained much of what they had lost – or perhaps even be higher – or perhaps the fall will have continued. No one knows for sure – but it shows the risk in the stock market Nobody knows for sure what is going to happen only that investing in the stock market can be very risky. It can also be very rewarding. If you are an investor in stocks, you should know what you are doing, or get good advice to help guide you. Otherwise, it can be a pretty scary place at times like these. So hold on – there is a good chance that these volatile times will continue. But hopefully we have helped you to understand a little more about why they are here.
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