Why are fantastic stocks sold off in a bear market?

March 28th, 2008

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We are now officially in a bear market for stocks. As of yesterday, the Australian All Ordinaries Index had fallen 21% from its 1 November 2007 high. At its lowest point in 18 March 2008, the index was down by 25%. Right now, the All Ordinaries Index is even lower than what it was 12 months ago. Not only that, the market is getting more volatile, with stock prices falling very rapidly (e.g. the infamous Black Tuesday happened in January 2008 when the Australian market fell by 7% in one day). For investors, there seem to be no place to hide in the market as it seems that almost every stocks are affected.

Contrarians such as value investors would love such a bear market because it is a great time for bargain hunting for good quality stocks. For this reason, they are often inaccurately misunderstood as ‘bullish’ as they get excited and greedy when the market as a whole is getting fearful. But this leads to another question. In a bear market, especially during times of panic selling, why would stocks of good quality businesses fall along with the bad ones? If good quality stocks are really that good, why would they fall in the first place?

The most common cited general answer to this question is that in a panic, animal spirits of fear takes over and the market as a whole becomes irrational. In other words, it is negative sentiment that drives such absurdity.

But we are not satisfied with this answer, for it sounds like a cliché to us. So, for those who are as dissatisfied as us, we will provide one of the many pragmatic reasons for such absurdity. One word sums up this reason: leverage. Today, there are so much leverage in the financial system and by extension, the market. Both retail and institutional market participants borrow and employ leveraged derivates (e.g. options, CFDs, futures, etc). The problem with leverage is that, when the market goes against you, your losses are magnified and you find that you are suddenly short of cash (to repay the debts, obligation, margin calls, collateral, etc). Sometimes, the only way to increase your cash level is to liquidate whatever you have- the good investments along with the bad. If enough people are in the same situation as you, this will result in widespread indiscriminate selling in the market.

Thus, weak hands’ forced liquidation due to de-leveraging results in indiscriminate selling. For those who are in a strong cash position, this can be an opportunity to exploit.

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