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opinion

The electronic ticker display outside the Toronto Stock Exchange Tower.Christopher Katsarov/The Globe and Mail

Surging interest rates started it, but something else has taken over – and now, mysterious but powerful forces are compounding the pain of the stock market rout.

When technology stocks started tanking last November, it was widely understood shareholders were selling in response to the threat of higher interest rates. Consumer prices were soaring, and central banks needed to act to contain inflation. But growth stocks often struggle when rates rise.

Six months on, expected interest rate hikes should have been priced into stock market valuations, but the rout hasn’t stopped. Actually, it’s spread to the broader market, with the S&P 500 index, the benchmark for North American equities, down 14 per cent year to date.

There are some obvious explanations for this. To start, software is the new oil sector, and the S&P 500 is now heavily weighted to tech stocks. Stalwarts such as Apple Inc. and Amazon.com Inc. have grown so large they comprise roughly a quarter of the index.

But there’s much more to it. Other very strong forces are also at play, and they rarely get enough attention or respect. Chief among them: The role margin debt plays in market downturns, the record inflation in financial asset prices since the 2008-09 global financial crisis and – most finicky of all – irrational investor psychology.

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Throughout the second half of 2021, there was a fierce debate among economists as to whether rising prices for everyday goods was merely transitory, or something much more systemic. What this debate was missing is that there was already inflation in the global economy – but it was in financial assets.

This phenomenon has received more attention of late, because it helps to explain why house prices have soared. But stock markets have also experienced intense inflation, and – arguably – that hasn’t received enough attention.

The Federal Reserve Bank of St. Louis, a regional branch of the U.S. central bank, tracks the value of the Wilshire 5000 – a broad measure of the total U.S. stock market value – relative to U.S. gross domestic product. In 2000, at the height of the dot-com boom, the stock market’s value was about 1.4 times U.S. GDP. The ratio then sank and took about 20 years to climb back to that level.

After COVID-19 hit, the ratio far surpassed the dot-com heights. By the start of October last year, the stock market’s value had soared to 1.98 times GDP.

Some people will use the term “bubble” for such a buildup – and for the tech sector, it clearly was. It’s a little too early to say that for the entire market, but financial metrics have a tendency to revert to their averages during corrections. There is still a lot of cash to be moved out of the stock market before it declines to even the elevated dot-com heights again.

Exacerbating this threat: Much of this cash could be moved by force, because a lot of it has been borrowed.

Margin debt is a measure of how much money has been borrowed for investing purposes. By October, 2021, American investors had borrowed US$936-billion to put into the market, up 72 per cent from February, 2020, and far above the historical average. With interest rates rising, the cost of borrowing this money to invest is getting more expensive.

The bigger fear, however, is that all this debt will create margin calls as markets tank. Using debt to invest enhances gains in rising markets, but it can do the inverse in down markets, because lenders will require their margin clients to put up more capital as a cushion against trading bets. If a client has all of their excess capital in other stocks, they will be forced to sell some positions, which puts more pressure on falling share prices.

In most downturns, what it takes to end the downward spiral is some conviction from investors sitting on cash that stocks have become cheap. This time, though, it’s much harder to gauge valuations. Crucially, age-old metrics such as the price-to-earnings ratio rarely apply to tech stocks, because so many of these companies do not, and have not ever, made money.

As for the tech stalwarts, earnings growth is slowing, as seen with Amazon this week. “Expectations looking ahead are for another deceleration in growth in the second quarter, as well as a likely long-awaited hit to profit margins,” Charles Schwab chief investment strategist Liz Ann Sonders wrote in a note to clients.

At the same time, one of the driving market forces over the past two years – retail traders – is disappearing. Traders in their late 20s and early 30s poured money into stocks, and at one point in 2021 accounted for half of all trades in Canada.

But they have been quick to flee, which is why Robinhood Markets Inc.’s share price is down 73 per cent since the retail trading platform went public last year, and the company laid off 9 per cent of its staff this past week.

With retail traders turning skittish, some large institutional investors may have to do the heavy lifting to turn the markets around – something Warren Buffett is starting to do by deploying his company’s cash. But they, too, have a lot to sort out – particularly a messy economic backdrop.

What it all means is that no one is sure of what normal look likes any more – and that’s when investor psychology is the scariest, because irrational behaviour can become the norm. The past few days of trading are proof of that.

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