The Market Crash Explained - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 20 August 2011
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- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
The last few weeks have seen heavy turbulence in the financial markets. Stock markets around the world have crashed, most commodities have crashed, and gold continues to break new records. Bond yields are falling as investors pile into safe haven assets. In the currency markets, the safe haven currencies have prospered, while the risk currencies have suffered.

The current market environment feels a lot like the environment in 2008 after Lehman Brothers collapsed. At the time, the same phenomenon was occurring; risky assets crashing and safe haven assets rising. Of course, there is one big difference. In 2008, the reasons for the market collapse were clear. It was due to a failure of Lehman Brothers and the corresponding financial crises going along with it.

The reasons for today's crash are much less clear. Today's market movements are difficult to explain in terms of fundamentals. But let's try anyway. So the first big event prior to the crash was the US reaching a deal to increase its debt ceiling and avert default. This should have been good news for the market, but it was not to be. In fact, the market crash started very soon after the US debt deal was reached.

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As the week went on, the markets got worse. Then came the next big event. The US credit rating was downgraded by the S&P, the first time in the country's history. When markets opened the following week, the crash continued and things got worse. Maybe this was the fundamental explanation we were looking for?

Not so. Following the US downgrade, US government bond yields fell and their prices increased. So investors bought more US government debt after the credit rating fell. Not exactly a sign that anyone was troubled by the idea of a US default. The bond buyers were right too, because the US will never default. Any country that has debts denominated in their own currency, and can freely print their own currency will never default. They can simply print the money to pay their debts, so default is not a concern.

Let's talk about Europe. One of the cited fundamental reasons for the market crash has been the debt concerns of certain European countries, namely Italy and Spain. Now here default is much more of a possibility than in the case of the US. This is for the simple reason that European countries cannot print their own currency, nor can they lower their interest rates to reduce their debt burden. Furthermore, when bond yields are rising (i.e. the market is less willing to lend), then we could have a recipe for disaster.

The Eurozone debt crisis is thus a legitimate concern for markets, and a good reason for why markets have crashed. However, the explanation is not fully satisfying. This is because the debt problems of Italy and Spain are not new news. In the last three weeks, there has been no increase in the default probability of either Italy or Spain. One month ago, Spain and Italy were just as likely to default as today, so why was the market not factoring this in much earlier? Usually, market crashes are triggered by some news or event that occurs. We haven't seen this in today's market environment.

There's another factor that could be the cause of the market crashes in the past weeks. Slowing economic growth around the world, and in particular the US and Europe. Over the last few months, economic data coming out of these countries has been getting steadily worse. GDP growth has been falling, unemployment has either been stagnant or gotten worse, consumers and businesses are losing confidence and spending less, and the list goes on.

All the above factors are negative for the economic well being of the world. Another additional factor is that government spending is falling, due in large part to the current political environment. When government spending falls and taxes rise, this reduces growth. Although fiscal prudence is necessary to reduce long term deficits and debt, it does put an immediate drag on growth.

Thus, we have a host of factors that are likely to be bad for global economic growth and performance. But, we'll make the same point here that we did when talking about the European debt crisis. This is not new news. Economic data has been worsening over the last few months, not weeks. Fiscal austerity has been talked about in the last few months and in the last year. Thus, nothing out of this can be pointed to as something that has directly caused the markets to crash.

This whole analysis leads us to the following conclusion: The markets may be crashing for the right reasons, but the timing of the crash does not make a lot of sense. Especially the significant daily falls that have been occurring. It appears that all of a sudden, investors have become aware of many of the problems in the global economy, and they are following a sell now ask questions later approach.

Obviously, large market crashes can reduce our wealth, especially as many of us are invested in the stock market. But this is not a problem if we are invested for the long term. The market will recover, it always does. In the short term, it is inevitable that much of market reaction is overdone, and thus we are experiencing high volatility with swings in either direction.

During periods like this, we can find good trading opportunities. When panic and fear are driving markets, it is highly likely, in fact nearly certain, that prices will deviate from their fundamental values. Identifying these opportunities can help us get through this turbulent market period without losing our shirts, and hopefully with a healthy profit.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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6 Responses to "The Market Crash Explained"

BYM

Aug 22, 2011

Although many financial advisors were bearish, it did not
help much as now investors/traders are the new financial
gurus....I find it interesting that even media many time
brings dealing desk guys to give view on markets.... :)

Like 

abhinay

Aug 22, 2011

Good article after a long time, otherwise most of the time it just the opinion of others...one of the stock which is available at good level is IVRCL...36

Like 

manoj paliwal

Aug 22, 2011

tata tvs rel

Like 

M M CHANDAK

Aug 21, 2011

The heading "the market crash explained" ran a hope within me that i will find the reason after reading the article for the irrational behavior of the market but even after reading the article twice i remain as clueless as before,

Of course the markets are falling for the right reasons but what are those?

Like 

Rajan

Aug 21, 2011

A Monday morning quarter backing article.

If as it says, all the elements of a market crash were there for a month, why did not the wise analysts/financial experts advise their followers to get out of the market and sit on the sidelines waiting for opportunities to buy in a depressed market later ?

A post facto analysis does not help

Like 

Govind

Aug 20, 2011

Moderate, consistent and long term are the key words for success in any domain. For example, Life.

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