Last week the Stock Market went through a correction. A correction is when stocks adjust, usually downward, closer to their actual values. Shares in a company have underlying value based on the company’s bonds, and their bond prices are based on the Treasure Bills. The reason a company’s stocks are primarily based off their bond is because bonds are debt, and the better a company is at paying back those debts the better an investment they will be in the long run.
The issue faced by financial markets and investors is that stocks begin to take on a life and value of their own once people begin to add subjective aspects to them. Things like how good management is, or how high sales are can be double counted into the stock price even though it is semi-involved in the bond’s value.
Stocks begin to inflate in price because most investors see stocks for their story. Whether it be the past performance being forecast into the future or excitement over an announcement of new sources of revenue, people swarm stocks after good news or ditch them after bad news.
So, what exactly happened?
We may never know, but it seems the market correction was spurred on by a couple of factors: markets were too good for too long, algorithms trading and people overreacting.
Consistent strong markets, is a common trend that leads up to a market correction, or worse. People see the markets continuing to go upwards with no sign of stopping and get excited at the potential to make more money. Investors quickly forget that financial markets have a down side, and so they pump money in non-stop expecting there will never be a downturn. This quickly leads to inflated prices for stocks worsening the fall.
Second, one should examine the algorithms involved. Algorithms are extremely complex set of rules to perform calculations. In the context of trading, they value stocks and trade on the values they assign. These algorithms haven’t caused much trouble aside from taking the jobs of some low-level analysts, but in this case, it happened that multiple computer-generated trading patterns picked up on investors dumping stocks while the markets were closed, and so when markets opened the computer traders only saw red and followed their protocol: to sell.
The second factor leads into the third, overreaction. Human investors saw the unloading of shares into the market and overreacted to save themselves from losing more money. This causes an all-out free fall of the markets. If these investors had seen what was happening, they could have reacted rationally, held onto their shares, braced the turmoil and the market correction would have been lessened.
In the end the stock market has rebounded and the correction was a minor hiccup with no observable lasting effects. Though, only time will tell if investors have learned their lesson or not.