Is forced selling the cause of the stock market drop?

Stock markets tend to be reasonably efficient in terms of evaluating stocks and where their momentum is likely to carry them. In forward and buoyant markets they price themselves upwards and vice versa.

In real terms, valuations of equities actually look quite cheap but that doesn’t mean they mightn’t get cheaper, a point the vultures surrounding Northern Rock will now know very well when they complete their accounts this year.

So whilst markets are efficient, you would therefore expect that a reasonably transparent stock would not be as volatile. The FTSE 100 is a list of the leading 100 UK companies. One might expect they would be very clear, transparent and easily valued with little or no volatility. Why could a price move so much if it was fully understood?

Markets are always trying to interpret forward movements. It’s a bit like heading out to sea with coordinates to New York, but a sharp wind could send you one degree off target, and without adjustment Greenland becomes a more viable destination. The further away a market is forecasting a share, the bigger the potential price differential and volatility will be now.

With so much volatility, markets are trying to predict the potential downturn and repricing stocks accordingly. Whilst this is fine and creates bargains if they get it wrong, the real problem has been created by the lack of liquidity in the market (basically not much money around).

This has then been married with forced selling of shares. Iceland and Korea for example have been selling overseas assets in an attempt to look after their domestic economy. Hedge funds are now facing forced redemptions after September’s poor performances, and a raft of potential bad news clouds the way forward. Lehman’s assets are soon to be auctioned off and the potential is there for big losses for some financial institutions.

There are quite a lot of oil and resource stocks in the FTSE 100 today and this is being hammered, as oil, along with other commodities plummets in value. This was inevitable as most of the food and energy costs were driven by commodity trading which has tailed off significantly, forcing oil down from $147 to $77 bringing oil stocks with it. On top of this there is the opacity surrounding banking and financial stocks which is weighing heavily. Solving a problem is easy, finding it is the tricky bit. Whilst there is the opacity surrounding financial stocks the market will remain volatile.

The truth is, the forced selling is one of the biggest drivers. Remember also that many companies have been unable to refinance as have many individuals. This log jam has meant that they have had to sell their investments. Everyone knows you buy low and sell high, but forced selling pays no attention to value. If it’s a case of cashflow, the money in your account is more important than future investments returns. In the meantime the Indonesian market remains shut and many emerging markets are looking very risky indeed when you look at their current account balances, debt ratios and funding flows. How much of this bad news pours into the market creates the reverse of the greed of the last sixteen years. As Newton’s law of motion knows, for every action there is an equal and opposite reaction, that’s why a plane is pushed and sucked into the air.

But remember this, the world needs to move forward, and the steps taken to shore up banks and free up cashflow will go a long way towards stabilising the market. Stabilising the economy is another task which will take a lot more confidence than we have.

Its worth remembering that much of this negative sentiment is priced into the market already. Will it go lower? Yes probably, but there will be no bells rung at the bottom and one or two bits of positive data coming through will surprise the market and the bounce will be pronounced. Timing that will be very tricky indeed.

If you have a financial query call Peter McGahan on 0800 0112825, e-mail info@wwfp.net

Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorised and regulated by the Financial Services Authority. ‘The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.’
Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made.
The above represents the personal opinions of Peter McGahan.
All information is based on our understanding of current tax practices, which are subject to change.
The value of shares and investments can go down as well as up.

Tags: Lehmans bank, Northern Rock, stock markets

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