What Causes Seismic Shifts In The Stock Market?

Attempting to predict the stock market, especially for a proprietary trading firm, can sometimes feel as futile as trying to predict the weather.

In fact, there exist financial instruments that reward investors who can appropriately predict the weather or at least hedge against its potential negative effects.

Both the weather and the stock market are similar in that whilst they are made of predictable and understandable variables, working out how they connect to each other is a labyrinthine task, with so many elements connected in such byzantine ways so as to appear unpredictable.

The market is moved by so many factors, and each purchase and sale contributes to almost imperceptible movements and shifts that create the moment-to-moment noise of the market.

Typically, however, amidst the noise and market murmurings is a relatively gradual trend, one that is far easier to understand, even if it can be difficult to truly predict at times given the volatility.

It often takes some particularly unusual scenarios and situations to create a seismic shift in the market, either a huge breakthrough causing a wave of positive market sentiment that causes stock prices in certain industries to rise exponentially or a sudden crash that wipes considerable value from the market.

Understanding where these shifts can come from often means looking into the past and seeing examples of massive movements, the trends that caused them, and what we can and have learned to spot their potential appearance in the future.

The Power Of Emotion

One of the golden, almost sacrosanct rules of trading is never to make a move purely based on emotion. Trading based on greed or fear is often when bad, costly moves are made, and makes a trader far more reliant on luck than they should be.

However, if you’re a rational actor in a rampaging torrent of emotional trading, it can cause some unexpected moves and the opportunity both for immense success or unfortunate failure based on how long the sentiment lasts.

The problem is that in the swirling hype machine, it can be difficult to determine the difference between a genuine trend that people are buying into at a price and time close to the ground floor, that is set to have a high ceiling, a surge of new industry energy that will settle in time, or a genuine asset bubble.

It is easy to tell that an industry is overvalued in hindsight, but it is difficult at the time to tell when the market will correct or whether it will react.

A lot of people lost money when the dotcom bubble burst, an asset bubble based on an optimistic view of the future of technology stocks that would take a bit longer to be as valuable as claimed at the time.

Stanley Druckenmiller, George Soros’ right-hand man in the Quantum Fund and the architect behind the famous and history-defining shorting of the British pound in 1992, managed to see the prevailing wind and still lose a lot of money by mistiming his shorts of dotcom stocks.

Short Squeezes

Both exceptionally rare, unusual and often seismic, a short squeeze is a situation where a stock that is subject to a lot of short-selling interest unexpectedly increases in price, which typically forces short sellers to quickly buy back shares to cover their position and avoid potentially unlimited losses.

There are a few cases of short squeezes causing strange shifts in the market, almost all of which are weird and bizarre in their circumstances and side effects.

There was the case of Volkswagen, which for a very short time became the most valuable stock in the world after Porsche attempted to take it over and reversed the bearish sentiment that had become endemic in the wake of the 2008 financial crisis.

The revelation of just how much stock Porsche owned meant that twice as many shares were shorted as actually existed, driving up the price of VW stock fivefold in just two days, making the company for a very short time more valuable than ExxonMobil.

In other cases, a short squeeze is executed as a deliberate tactic, such as the infamous and illegal case of MAAX Holdings and Philip Falcone.

Mr Falcone bought the entire issue of stock bonds and lent them to short-sellers but refused to allow them to liquidate their positions unless they contacted him directly, leading to a short squeeze that ultimately forced him to admit to breaking the law, pay millions of dollars in fines and was banned from securities trading.

By far the most recent and weirdest example was the short-squeeze of video game retail chain GameStop in January 2021.

The retailer was seen as almost destined to go bankrupt, so it came as some surprise that the stock rallied in part due to a loose association of independent traders using online investment forums who spotted the potential for a short squeeze after seeing particularly reckless short positions.

As much as 140 per cent of existing GME shares had been shorted, making it the most shorted stock in the world at the time, and the short-squeeze, which boosted GME’s value from $17.50 to over $500 in a matter of weeks, forcing many short-sellers out of their position and in some cases into bankruptcy.

The general way to avoid being caught out by a short squeeze is to avoid shorting if the potential risks are too much to bear.

Some Surprising News

Earnings reports can lead to more volatility, as people await confirmation of reports and rumours ahead of their publication, but a sudden surprise can lead to a huge change in the landscape of the market and rapid buying or selling activity.

Porsche’s revelation of just how deep its holdings in VW were at the time led to the biggest short squeeze in history, and other earnings calls that provide either unusually good or unusually bad news often lead to a snowball effect as people rush to buy or sell.

A very good example of this is Meta Platforms, formally Facebook, revealing a somewhat mediocre earnings call compared to expectations from financial analysts, which had helped to elevate the stock for the previous week.

The stock lost $232bn in a day, the single biggest one-day loss in the history of the stock market, and shows how the slightest snag can snowball at times.

Exactly what to do next depends on the company that feels the wrath of bad news. In some cases, it is worth considering buying the dip, but in others, it can be a sign of a general market correction.

Contagion

The stock market can feel like a living ecosystem at times, because of the ways in which small market movements can have huge consequential effects, much like the flapping wings of a butterfly causing a hurricane on the other side of the world.

Financial contagion is the term used for how the interconnection of the global financial market means that financial shocks or crises tend to spread throughout the market, as the effect of a significant crash of a single stock can spread to an entire asset class, a regional market or the entire system.

The first time the term was used was during the 1997 Asian Financial Crisis, where the fall of the Thai baht led to several other connected currencies in Southeast Asia suffering similar pressures, including the South Korean won and Indonesian rupiah also falling significantly.

The effects can be wide-reaching and sometimes very unpredictable, with a good example of this being the huge footprint of the subprime mortgage crisis.

The housing asset bubble in the United States and the defaults that ensued when the bubble burst had huge, far-reaching effects because of the sale and distribution of mortgage-backed securities, an asset class that had largely caused the boom in the first place.

Many seemingly too-big-to-fail institutions proceeded to collapse as they were caught in the contagion, and others were brought into national ownership such as Northern Rock.

Governmental Intervention

One of the biggest causes of seismic shifts in the stock market is the influence of governments and major public institutions, which typically will affect stock markets in a variety of ways.

The most common example is in the way that national banks will set their interest rates, which affects the cost of borrowing, usually affecting inflation, the cost of living and levels of disposable income, all of which affect stock prices.

They often will also set a financial budget, which in turn can have huge effects on the financial market as certain policies can benefit some industries over others, especially if tax rates change or government funding is announced for certain emerging industries.

The 2022 Autumn mini-budget was an infamous example of this, as the International Monetary Fund took the rare step of openly criticising it.

The pound sterling plummeted, causing a knock-on effect on companies trading on the London Stock Exchange, the government that enacted it was the shortest-lived in the history of the country and it caused chaos in the financial markets.

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