Why does everyone panic sell (market crash) during bad, but temporary, conditions (as seen with COVID-19)? Why can't everyone agree that the companies most likely won't go bankrupt and will eventually return to normalcy (revenue, popularity, influence), and hold their stocks, which in return would prevent a market crash? This idea of people buying stocks without any benefits from the company's performance (excluding dividends) in hopes of the more guys buying it (stock price going up)...and more guys...and so on confuses me.
While in the long run markets are assumed to be efficient, in the short run they are mostly driven by behavioural speculation. If I think that something bad is coming and I think that other people think it too and I believe other people will react to this knowledge by selling their assets, it is a completely rational decision on a personal level to try and time the market by selling first.
Moreover, there can be completely rational reasons to sell, even ignoring what other people think. Lockdown measures are bad for a cinema chain. People staying from home won't buy as much fuel and so on. Companies will conduct layoffs and people who have just lost their job probably won't buy a new car or whatever, affecting other sectors as well.
Remember, despite huge stimulus packages (an extent that most people would not have expected in early March 2020) all over the world, GDP has been shrinking considerably in 2020 and many companies have severely cut their dividends. And these are just the tip of the iceberg as your favorite restaurant probably is not listed on an exchange. These are fundamental reasons for an investor to sell.
The problem is, a decision targeted at your own advantage may not be an advantage on collective level. No matter whether people are trying to jump the gun by selling first or aggressive lane weaving during rush hour.
Let’s drop the idea that crashes are the irrational response to bad news. Many of the worst crashes in history were preceded by no news at all. I am not saying that a crash might not be an irrational reaction, but irrationality is unnecessary.
For example, neither the 1929 crash nor the one that followed a few years later happened in what could be considered an overvalued market. About a month before the crash, the Federal Reserve misread economic signals and contracted the money supply by three percent. Ultimately, a quarter of the labor force would become unemployed by that three percent change. Economists worry about seemingly small changes because they can have outsized consequences. Ultimately, the entire banking system collapsed.
There appear to be multiple causes for crashes. Still, they seem to be explainable by changes in the supply or demand curves.
The 1987 crash was also a liquidity crisis. Falling markets began in Europe. They lost enough that Margaret Thatcher called President Reagan in case they needed to coordinate action. Traders reported that they came to work expecting a bad day. They arrived to a market filled with sell orders but no buy orders. Interest rates had increased, and side contracts absorbed all of the market’s liquidity, leaving no money for regular trading operations.
Of course, other markets crash. Oil prices fell so far that their prices became negative. The cause of the negative prices was that so much oil had been produced that there were no storage facilities for them. The rents were so high that the cost exceeded the value of the oil.
Some crashes are due to valuation. The tulip bulb crash was a valuation-led crash.
The initial runup in prices for tulip bulbs was totally rational in any framework. Unfortunately, prices grew substantially. A single tulip bulb, at one point, was worth the price of a ship, the pay for the crew, and a full load of cargo. A handful of bulbs were worth an entire duchy.
There are many problems with tulip markets. One of them is that if you have enough time, you can grow many, many more than before. If you grow enough, bulbs are with pennies.
That sounds irrational, and it is, but not in the way that you are thinking. All of us have reservation prices for things. If you like oranges more than apples, your reservation price for oranges will be higher than for apples. There is nothing at all logical about preferring one over the other. Preferences are irrational, by definition.
If a security is only held by the people that value it the most, the only thing it can do is crash. If group A values an asset at $200 while group B values it at $100, then if the budget constraint of group A becomes binding and there is a forced sell, the only parties willing to buy it are people in group B. The double auction nature of the capital markets limit that type of event, but do not foreclose it from happening.
Humans engage in rationality when they are in a state they do not like. When they are in a state they like, they do not need rationality.
Nobody with three children looked at the back of their minivan and realized they must have another child as there is an empty seat. Nor has any family with three children realized they have a place setting for six and need one extra child so that the dish does not go to waste.
If a baby cannot be afforded, then people use logic and reason to analyze the situation. Otherwise, they just have babies.
There is indeed an equilibrium condition that a current price must equal the discounted cash flows from the underlying security, which implies that the price should also equal the replacement cost of physical capital at the margin. Markets do not have to be in equilibrium. Indeed, we couldn’t identify the idea of an equilibrium if markets were always in one.
Sometimes markets crash to an equilibrium price. They also, sometimes, fall below it. Sometimes they began at an equilibrium price and still collapsed. Crashes usually happen when the status quo cannot be maintained because a driving variable has changed, even if not permanently.
Finally, had you bought the Dow on January 1, 1929, and a friend purchased treasury securities, neither of you paying transaction costs or taxes, then you would not catch up to your friend in reinvested value until January 1, 1963. It is true that you would have broken even within ten years, but your friend would be way ahead by that time.
The long run can be a long time.