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Stock Market Crash of 2020

The stock market crash of 2020 already has a Wikipedia page of its own. If you are a student of economic student then you will be aware that the great depression was also triggered off with a major stock market crash. The crash of 2020 has got similar signs attached to it. In this article we will attempt to understand just how this crash was caused and what it may imply for the future.

In order to understand this, we first have to travel a few months back. Late January to be precise. This was around the time when the news of a virus spread in China began to grab headlines across the world. Investors in major stock markets were cautioned a bit but everyone at this point hoped that the virus would be contained in China.

January passed into February and shocking images and clips were flooding out from China. At first Wuhan city was quarantined, then Hubei province and then the number of provinces that were under quarantine began increasing. At this point the level of fear and panic among the investors began to increase.

This graph shows the price of a troy ounce of gold and it can be seen that the price of gold began to spike up mid February. This was the time when investors were in the panic mode. China was rapidly going into a very draconian quarantine and cases from Italy, USA and other places were starting to pile up. Investors naturally turned to gold that is considered as a safe haven, next to government bonds.

Around the same time the stock markets across the world began to crash. So now we can connect the dots here. As the news of an international pandemic spread, the investors panicked and began to sell their investment in stocks and instead went for either gold or government bonds, as safe havens to protect their investments.

The graph above shows the position of Dow Jones industrial average around the same time. It can be clearly seen now that as the down plunged, the value of gold rose.

Now many investors diversify their portfolio by investing into shares, government bonds and then keeping a minimum of their investment in gld. Although gold is a safe haven but many investors do not prefer gold because it does not carry periodic returns. Gold cannot give you interest or dividends whereas stocks and bonds can. Therefore gold is an asset of last resort.

Bonds however are an asset of choice for many investors because when stocks go down, the value of bonds rises as more investors demand bonds. So any loss in stocks can be offset by the rise in demand of bonds and vice versa. This is the normal relationship between stocks and bonds, however when the stock markets began to crash in late February, this relationship failed to live up.

Investors were not only taking their investment out of stocks but they were also not demanding government bonds. Instead investors it seems lost complete confidence in the global financial system because they were demanding cold hard cash.

American dollars therefore increased in demand and whenever the demand of anything increases, its price also increases and this is exactly what happened.

As investors liquidated their investments, the price of dollar rose, as we may see on site. The dollar strengthened against other currencies. While this may be seen as a good sign, on 23rd February this wasn` t a good sign for America and the world economy. Why? Because strengthening dollar meant that it was not expensive for other countries to import from America.

The fact that investors were liquidating their investments caused the dollar to rise in value and thus it threatened international trade. The US government had to intervene to stabilize the dollar but it was now already too late.

In a desperate effort the Federal Reserve slashed the interest rates to try and stimulate the economy by inducing people to spend more but this strategy did not work. Why? Because people simply were not willing to spend anything as the threat for them was the virus. Producers were worried too because supply chains from China had shut down.

By mid march, Federal Reserve had exhausted all of its policy options. Everything that the Federal Reserve had done in 2008 to contain the financial crisis, had now been tried by FED and it had failed. Why? Perhaps because FED was only treating the symptoms instead of directly looking at the problem, the root cause that was the virus. But FED cannot do anything about the virus so the second most obvious root cause was credit.

Credit bubble had caused the crisis of 2008 and the same credit bubble was now causing the global financial system to convulse dangerously. A point came in March when even financially strong corporations like Apple couldn`t get anything but over priced 3 month debts. Many corporations came close to defaulting. The American corporate sector was about to collapse when Federal Reserve decided to take a very desperate step on 23rd March.

FED never directly intervenes in the market and it certainly doesn`t provide debt to corporations because doing so would fuel he debate of favoritism. But this is what FED did. It established a special purpose vehicle in order to provide loans directly to corporations.

By the end of March, the Federal Reserve was increasing debt by the rate of $1 million per minute. On April, the Federal Reserve announced to increase the extent of its support for the market by also funding to states and municipalities.
Experts are of the opinion that in this last ditch attempt to save the corporate sector; Federal Reserve may have made a mistake that will cost dearly in the future. Basically more debt is being used to support the corporate sector that was already going to collapse, due to the unavailability of cheap debt. For the time being, it seemed to have worked because after the historical market drop of 23r March, the stock markets seem to have regained almost 50% of their lost value but keeping in mind that the virus is still out there one has to look at this in a very prudent manner.

There will be more shocks, the demand for oil has tanked and similarly if there are other such shocks, will the high rate of debt that is being pumped into global economy right now, be able to support the crippling economy? Experts believe that this has only worsened the situation but only time will tell us who was right.
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