What have sunspots got to do with market crises

Nithya Sridharan

It’s devastating to see the financial markets plunge due to the recent spread of COVID-19. On March 9, also dubbed as Black Monday, the S&P 500 crashed 7.2 percent, and the FTSE 100 nearly 9 percent, the biggest fall next only to that of the 2008 housing crisis.

While the 2008 crisis was largely caused by factors related to market fundamentals, the March 2020 crash was over the spread of a virus, something that affects every industry and sector, not just finance.

What is the intuition behind the fall in the markets due to something global (like a pandemic) even before the full facts are known? Is the scale of the sell-off adjusted to the factual information available? More broadly, is there a difference between how facts, and to borrow a phrase from the political landscape, alternative facts, or even fear, can impact the market sell-offs?

This is not the first black Monday. The one before is definitely senior in terms of market losses. On October 19, 1987, the Dow Jones Industrial Average fell by 22.7 percent and the S&P 500 by more than 18 percent. Global stock markets saw similar large declines.

Hindsight being a wonderful tool, various scholars have analysed the triggers for this decline. The key information-based triggers pointed to a tax bill being passed in the US House Committee that would reduce the tax benefits associated with financing mergers and the announcement of the fact that the US had a large trade deficit.

Furthermore, the scholars found that the crash was exacerbated by the fragility in the markets and a flaw in IT (information technology) systems which couldn’t deal with the sudden increase in volume of trades and the fact that derivatives and stock markets were out of sync.

But let’s be clear, there was a strong element of panic or fear in the market sentiment regarding the future. Not all  market participants knew the information on the tax laws nor were they aware of the IT flaws. While there were various reasons that could have triggered people to take a dim view of the future, it was definitely influenced by views that people had a hunch about.

In fact, this is clearly brought out by the work of the Nobel-winning economist Robert Shiller. He interviewed 1,000 investors to understand their experience of the crash and its causes. Ironically, very few investors attributed the sell-off to the tax law. Most investors apparently had a “feeling” that there was too much indebtedness. While there were some systemic flaws, public sentiment played an important role in this crash.

In contrast, the 2010 flash crash, which led to a short, yet steep decline in the stock market, was primarily attributable to the effects and impacts of high frequency trading, i.e. a flaw in the system. This was not driven by sentiment.

So, there are two categories that can influence the market: intrinsic factors that are related to market fundamentals and then extrinsic ones, like panic based on a gut feeling, or a hunch about something. In reality, these factors can be quite co-mingled.

It is certainly not intuitive that a premonition or a hunch or panic caused by animal gut-feelings alone can change the total dynamics of markets globally. Some intuition behind this behaviour comes from the work of economists David Kass and Karl Shell, who analysed the role of “sunspots” and market fragility.

Sunspots are temporary spots in the sun’s photosphere. Kass and Shell use this term to refer to extrinsic factors unrelated to economic fundamentals such as animal instincts, gut feelings, self-fulfilling prophesies and so forth. They were inspired by a William Stanley Jevons' research work in the 19^th century which analysed if there were correlations between actuals magnetic fields spots in the sun and the economic business cycles! While this 19^th century economist did not manage to prove this correlation in his theory, isn’t it curious that other studies actually show that sunny weather influences stock returns positively.

Through their research on sunspots, Kass and Shell prove that in a world where markets are complete and satisfy a few theoretical ideal economic conditions, these extrinsic sunspots have no impact on the market. However, unfortunately this utopian paradise doesn’t exist in reality as currently markets are not complete. There are several gaps such as lack of information transparency, a non-homogenous set of beliefs among investors due to various reasons and all investors not being rational all the time.

In reality, more often than not, a firm “belief” about a negative future can even become a self-fulfilling prophesy. Even bank runs could come about by people withdrawing money based on a hunch that the bank is not stable, but the very act of many people withdrawing money simultaneously leads to increased probability of default of the bank, which could have well been in stable health.

Pandemics and epidemics are special cases, where it is quite hard to separate extrinsic and intrinsic factors. It could very well start off being a sunspot (i.e. something that people fear, even without the complete set of information being available). But then, if more information becomes known about the pandemic such as massive lock-downs of several nations and possible long-term impact of economic activity, it quickly morphs into factors that are fundamental to the economy such as fall in GDP.

With increased globalisation and generous minute by minute coverage by the media and the social media, the panic induced in the system is greater than before. While the initial sell-off is a sunspot effect, the projections of the real economic impact of the pandemic itself are huge and fundamental to the economy. Re-assuring steps to combat the economic crises by policymakers and governments play a critical role in containing the damage to the economy.

In summary, markets are not perfect. These are increasingly connected, global and complex. Their fragilities are exposed under stress. Public sentiment is a key factor in markets and can cause huge swings as long as enough people take that view even though it might not be the truth. If we do want to keep our markets safe under the coronavirus impact, the advice stays the same: wash your hands and don’t panic.

Nithya Sridharan is a banking and finance professional. Views expressed are personal.