It has been a volatile week for stock markets, including the Australian Stock Exchange, which entered a correction – a drop of 10% or more from its most recent high. There have been 24 global corrections since 1974, and five have led to a recession.
Should we be worried?
What’s causing the crash?
The U.S. Federal Reserve (equivalent to our Reserve Bank of Australia) has been predicting a rise in interest rates for some time, making it more expensive to borrow. Last week, they stated explicitly they will start raising rates soon, most likely in March.
That, plus uncertainty about Omicron, global supply chain issues, high government debt, and a potential war in Ukraine, have spooked markets.
What do you mean ‘spooked’ markets?
When investors decide how much they’re willing to pay for stocks, they take their expectations for the future into consideration.
If they are optimistic about the future, they’re willing to pay more, because they think the returns will be higher. But if they’re pessimistic, they’re not willing to pay as much, or alternatively, they might be eager to sell stocks they own.
Stock markets can crash when a collective optimism swings suddenly into pessimism. Experts call this a ‘bubble bursting’. To spot bubbles, experts look for signs of over-optimism: is an asset (like a house, a stock, or a crypto coin) priced much higher than its underlying fundamentals can reasonably justify? It might be a bubble.
The bubble ‘bursts’ when investors in the market decide suddenly that the asset is overpriced and rush to sell it. The resulting ‘correction’ (a crash in the price of the asset) can lead to a recession, a period of economic decline characterised by rising unemployment and falling incomes.
For example, the Global Financial Crisis in 2008 was caused by a crash in the U.S. housing market, and the ‘dotcom’ collapse in the late 1990s was caused by a crash in the market for Internet-based start ups.
Is a bubble about to burst?
Some experts warn a global correction is looming on a similar magnitude to the dotcom bubble.
They’re calling it a ‘super bubble’ because it’s not confined to a single asset – the prices of tech stocks, housing prices and a range of other goods and services could be ripe for a major correction.
However, there are some experts, particularly in the U.S, who do not believe it is time to be alarmed.
Stephanie Roth, a senior markets economist at J.P. Morgan Private Bank, said corrections “are not very rare… but of course every time you’re in one, it doesn’t feel good”.
Ted Jenkin, CEO and co-founder of oXYGen Financial says “the most important single thing in this situation is knowing what your financial plan is telling you what to do. If you have five or more years you can be in the stock market, you don’t really have an issue with what happens day to day or week to week.”