When Stocks Fall Irrationally

Singapore’s stock market barometer, the Straits Times Index (SGX: ^STI), is today some 15% lower than a 52-week high of 3,550 points that it reached in mid-April this year. Does the fall make sense?

Sometimes, stock price declines are warranted due to a deterioration in business fundamentals. In other instances, stock prices may fall for reasons that are far detached from how the business is performing; one great example is forced-selling from investors who had borrowed to invest.

A vicious cycle

Investing with borrowed money is also known as investing on margin. When stock prices fall, market participants who had bought stocks on margin are often required by their brokers to top-up more cash in their accounts – that’s what is known as a margin call.

If the margin calls can’t be met by the market participants, they will be forced to sell their stock holdings at prevailing prices. This forced-selling can easily cause share prices to fall further, causing even more margin calls to be met for other market participants.

As you can see, this can become a vicious cycle of falling share prices leading to even more declines. The cycle will continue until its fuel burns out, or in other words, when market participants who have bought stocks on margin have sold off most of their holdings.

According to a recent interview of Erwin Sanft from banking group Macquarie by business newswire Barron’s, China’s stock market had recently seen such a dynamic play out, though forced-selling by investors to meet margin calls there are now mostly done (this is also known as a credit unwinding).

Lesson learnt

The forced-sale of stocks points out two important things about investing.

Firstly, leverage is a double-edged sword. When the stock market is in a bull run and prices are climbing all the time, those who invested on margin may reap fantastic rewards and be seen as geniuses. Yet, when the market turns south – as it inevitably will from time to time – the use of leverage can easily leave these ‘investors’ with harrowing losses. Sometimes, they can even lose more than their capital.

Secondly, forced-selling can result in stock prices falling for reasons that are separate from business fundamentals, as I had already mentioned. This can then create bargains as a stock’s price may reach an irrational level that’s way below its intrinsic business value.

Foolish Summary

Many companies in Singapore would have seen their stock prices decline over the past few months. Some of them may have fallen due to a deteriorating business outlook. But, some may have fallen for technical reasons that have nothing to do with their business fundamentals (we’ve seen how forced-selling due to margin calls is one example). The latter group can make for some tasty bargains.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn't own shares in any companies mentioned.