A stock market postmortem reveals a ‘Black Wednesday’ culprit

What is to blame for the over 800-point plunge in the Dow Jones Industrial Average and the 4-percent drop for Nasdaq last Wednesday? The short answer is, nobody knows.

However, the Fed’s interest hikes and the unsettling trade tension between U.S. and other countries certainly received the loudest credit. But just because these were the two loudest answers, does that mean they are the most accurate?

{mosads}To answer this question, let’s look into the fundamental principles under which the stock market operates. One defining principle of the stock market is that it responds to unexpected news, not stale news.

The Fed announced the most recent interest rate increase on Sep. 25 and made it evident that a fourth hike was to come at the end of 2018.

It is hard, if not impossible, to imagine that U.S. capital markets, which take as little as seven milliseconds to incorporate Federal Open Market Committee (FOMC) meeting news into futures prices, really need three weeks to react adversely to the Fed’s past moves. 

One thing that the stock market really dislikes is uncertainty. Once the cloud of uncertainty hangs low, a subset of investors immediately assumes the very worst and cannot wait to sell.

If the uncertainty about the trade tension between U.S. and other countries, especially China, was the major concern of investors on “Black Wednesday,” it is expected that companies with the largest exposure to non-U.S. business activities would be hit the hardest. The data seems to agree with the conjecture.

Trinseo, the largest decliner on the New York Stock Exchange last Wednesday, lost over 20 percent of its market value in a single trading day. The company is a leading global materials company in synthetic rubber, latex binders and plastics.

Sales made to U.S. customers accounted for 14 percent of its total 4.4 billion revenue in 2017, while sales made to non-U.S. customers accounted for 86 percent.

In its most recent Securities and Exchange Commission (SEC) filings, the company singled out the importance of the Chinese market and stated that “sales to external customers in China and long-lived assets in China represented approximately 7 percent and 13 percent of the total for the years ended December 31, 2017 respectively.”

The story about another big decliner, DSW, which lost over 12 percent of its market value last Wednesday, has a slightly different twist. DSW, a footwear retailer, made most of its sales within the U.S.

However, in its annual filings with the SEC, the company stated that “almost all the merchandise we purchased during fiscal 2017 was manufactured outside the United States, and the majority was manufactured in China.”

What happened to Trinseo and DSW last Wednesday points to the same message: Companies that rely heavily on foreign countries, China in particular, in terms of either customer markets or supply chain, were affected most by the uncertainty surrounding the administration’s trade policies.

Another way to prove or disprove the hypothesis is to follow the folk wisdom of, “The greater the fall, the grander the ascension.”

If the trade tension was to blame for the big sell-off last Wednesday, it will be interesting to see whether Trinseo and DSW stock bounce back sharply if and when the uncertainty over the U.S.-China trade tension dissolves in a significant way.

The next thing to watch is how U.S. leaders interact and communicate with leaders from the rest of the world at the Group of 20 Buenos Aires summit on Nov. 30.

On a related note, though investors were unlikely to respond to the Fed’s latest interest rate hike last Wednesday, recent movements on stock markets and bond markets shed some light on the market’s perception of inflation.

One of the most interesting phenomena of the sell-off, aside from the big slide itself, was that, while stocks were down, bond yields moved higher. When bond yields moved higher, algorithm-based trading strategies also moved money away from loss-making stocks into bonds.

In a low-growth and low-interest economic regime like the one we have experienced over the past decade, bond yields typically move in positive tandem with stocks. With the recent negative tandem moves (yields up, shares down), it could signal inflationary pressure if such a trend continues for an extended period. 

Philosophically, “Black Wednesday” could be just one manifestation of the unresolved conflict between the globalization of the economy, on the one hand, and the inherently local nature of politics and national policies, on the other.

As long as the conflict continues to stay, “Black Wednesday” could be a more frequent occurrence than Wall Street would like it. 

Vicki Tang is an associate professor at Georgetown University’s McDonough School of Business.