Why the stock market collapsed

Why the stock market collapsed

Photo : Dr. Vishnu Bisram

Guyanese and other Caribbean Americans cried that they have lost their savings when the New York stock market collapsed on Monday February 5. The stock market in the US experienced crash like symptoms on Monday continuing a trend it experienced last week. The US market had its single largest decline in its history on Monday – some 5% or trillions of $ in value. By the way, not only in the US, the market “crashed” in several major countries this week including Japan, South Korea, Taiwan, Australia, India, Hong Kong, and Europe all losing between 2 to 6% in value. In Europe early trading on Tuesday, the market fell by 2%, and it continues to fall in Asia. The global trend has been that whenever the US market falls, international markets follow suit.

Tens of millions of Americans, including many Guyanese, Trinis, etchave their savings invested in the stock market either directly (trading in stocks) or through some pension funds (called 401 plan that is taken from payroll before taxes and invested as a retirement fund). Guyanese I spoke with complained that their savings have been wiped out over the last two days of NYSE trading. There were similar complaints in 2008 and 2009 when the market also experienced crash like symptoms that saw the value of peoples’ investments evaporated – trillions of dollars in value of stocks just vanished.  There was a similar occurrence over the last two days of trading with the market losing some $4T in value. The truth is peoples’ money did not disappear because the market (unless the stocks were cashed in at a low value) recovered and the value of most of the stocks was restored. There is usually a market course correction to reflect true value, and then it sees an upward trend again to be followed by a course correction.

Why did the US market experience a sharp decline over the last two trading days? Varied reasons are offered. Many economists say this was just a market course correction because the market experienced a sudden boom over the last couple of months and that it was bound to fall. The market grew over 20% since Trump became President with his promised tax cuts. It was rising continuously and rapidly and as such it was bound to collapse in a course correction.

But from my teaching about the Stock Market in my Economics class, fiscal policy (taxes) and monetary policy (interest rates) have a significant influence on the market.  In this case, fiscal policy did not have any significant influence on the fall of the market. If anything, it led to a market boom in late December after the huge tax cut. 

In the US case, the U.S Federal Reserve, America’s central bank, has been sending signals that it will hike interest rate (called the discount rate) that it lends to banks. The last time it raised interest rates, the market experienced a jolt and then stability. In 2008 and 2009, the Feds lowered interest rate to almost zero percent and the market boomed. When Trump signed into law the largest tax cut in history last December, the market ballooned.

An increase in the interest rate means that banks will likely raise interest rates themselves, passing the cost on to the customers. This makes loans and credit cards costlier affecting consumers’ habits and therefore takes a toll on the economy. Once consumer demand is down, businesses stagnate or decline in output taking a heavy toll on the economy. A hike in interest rates also affects financial performance of companies that have to borrow money to invest or to conduct business. Since they have to pay more to conduct business in rising interest costs, and returns are not guaranteed to recover costs, it slows down investment and by extension business expansion. The economy suffers. The stock market shrinks.

Also, higher rates generally encourage people to save more rather than spend and invest in an uncertain economy. So money is not invested. And people don’t borrow as much as before for consumption or for new undertakings like buying vehicles or luxury items or homes. Housing construction, which drives the economy, is affected as people hold off in purchasing homes. Overall, with a hike in the discount rate, there is lower revenues for businesses including banks which also don’t want to take too many risks in lending money to companies or people without safe collateral. And since stock market shares are directly influenced by how companies perform financially, people will not buy shares of companies that they perceive won’t do well or from which they won’t earn dividends. Stock prices fall, and cumulatively, they have an impact on the overall market. In short, the market tumbled on Friday and Monday (and maybe in days to come) because of perceived higher interest rates from the Fed. The Trump Administration may move in to calm the market by announcing interest rates will remain stable or may even experience a cut by a quarter point.

Guyanese and other Caribbean American investors need not be too overly concerned and irrationally take action to move their money out of stocks -- not just yet. The market will correct itself in weeks to come – the value of their stocks will recover. But they, like others who own stocks, should re-consider in which stocks they invest as the market will not forever climb as the US economy will also experience a course correction in the not too distant future. The US economy, as Nobel economic laureates warn, will face the consequences of the huge tax cuts of last December in years to come.