Massacre in the Markets

1. How it started. 2. Why it's happening 3. How to react.

What on earth is happening to my moneyyyyy? In short - were seeing a major sell-off in all markets. The riskier the asset, the more severe the impact. Stocks, and especially crypto, are seeing major retractions. Is there light at the end of the tunnel, or is the worst yet to come? This article investigates how it all started, why its  happening, and what the best course of action is. 

How it started

Covid19 hit hard, real hard. People lost their jobs. Businesses closed their doors. Economies were spiralling down, and so, it was time for someone to do something. Who would be our knight in shining armour? Of course, it could only be One The Fed. Their goal: To save the economy. 

[Insert: The Government and the Fed are not the same entity. The Fed is the central bank of a country and the personal bank of the government. South African Reserve Bank (SARS) is the central bank in South Africa, whereas the Federal Reserve (Fed) is the central bank in the US].

How? Via a process called quantitative easing, or QE for short. Essentially, the Fed prints money by providing loans to governments, banks, and companies, as well as social grants to its citizens. They also decrease interest rates, which in turn causes interest payments on loans to decrease and incentivizes people to take out new loans to purchase goods and services in the economy.

Governments, businesses, and individuals use this influx of money to pursue new opportunities and to buy assets, such as real estate, stocks and crypto. The problem, however, is that via this process, these assets are artificially inflated because the money that was used to acquire them appeared out of thin air (quite literally). 

For example, in the middle of the covid pandemic, the US unemployment rate and the S&P500 were both at historic highs, at the same time. This doesnt make sense: the economy was on its knees, yet the stock market (which is supposedly a reflection of the state of the economy) was thriving. 

Figure 1 illustrates the severity of money printing by the fed in recent times. Quantitative easing is not a bad tool to boost the economy in difficult times, but when it is done like this, it can potentially have severe implications down the line.

Why its happening

One word: Inflation. This year, governments across the world have reported some of the highest inflation numbers in decades. High inflation poses a serious threat: Not only does it lead to sustained and significant increases in the prices of goods and services, but it also leads to the devaluation of our currencies. 

Once again, the Fed must step in and save us. What action do they take this time? Well, they do the opposite of what they did last time - they increase interest rates. Higher interest rates decrease the money supply (lower inflation), as well as the values of our assets.

Money supply: Higher interest rates means that borrowers (which is basically everyone), are now required to pay higher interest on their loans. Additionally, it disincentivises the acquisition of newly issued loans. This inevitably leads to a decrease in the money supply.

Asset valuations: The most popular asset valuation method is the discounted valuation model. Analysts estimate future cash flows for businesses and then discount these cash flows back to the present day. This is how they arrive at its valuation, called the present value or intrinsic value. The main variable in this discount rate is the interest rate. So, higher interest rates lead to higher discount rates which leads to lower valuations. 

Finally, people realize that assets across the board are inflated. Fear sets in as we realize that the situation is much worse than we originally thought, which leaves investors with only two options: Sell assets for cash, or exchange riskier assets for safer assets. And just like that, theres a sell-off across the board. The riskier the asset, the more severe the dump. This is why crypto (especially altcoins), and stocks (especially tech and high beta stocks) are hit the hardest.

How to respond

Excessive quantitative easing led to unprecedented increases in the money supply. This newly issued money had to make its way into the economy in some or the other way. Inevitably, a chunk of this money made its way into exciting ideas such as tech stocks and cryptocurrency. Prices soared and people made BIG bucks. 

BUT, this led to overexuberance and overconfidence in the markets. Inflation hit, the fed stepped in by increasing interest rates, and the market was exposed for its greed. The rest, as they say, is well future? Yes, this is happening live, ladies and gentlemen. [refer to figure 2]

Relax, take it eaaaaaaaasy, cause theres nothing that we can do. First and foremost, we have to stay put for now. We cant panic, and we probably should not sell at these levels. But its so bloody. Its okay. These things happen. In the meantime, lets focus on what we can control: Learning from our mistakes.

Lesson 1: Never invest what you cant afford to lose
Are you financially dependent on this money? Are you losing sleep over your investments? If so, youre doing it wrong. Investing should be a journey that gives us joy and builds our wealth over time. It should be a value-adding and empowering experience, not one that creates stress. 

Lesson 2: Know what you invest in
This is especially true for tech stocks and cryptocurrency. Markets create a lot of hype. Many investors FOMOd into projects which they do not understand. Always know what you buy. This will help you hold on during tough times, and not sell at the whiff of profits.

Lesson 3: Be greedy when others are fearful
Market psychology is a fascinating subject. Once we see big green candles, we want more, and once we see big red candles, we want out. You must purposefully train yourself to think in the opposite direction, especially when theres blood on the streets. Red is sexy. Red is opportunity.