Photograph by ChinaFotoPress/Getty Images
By S. Kumar
August 26, 2015

U.S. equities rebounded strongly early Tuesday — only to fall again by the end of the day. Despite the continuing volatility, nothing much really changed since the start of the week except investor sentiment. And therein lies the clue to why another crash could be coming.

Monday’s frantic sell-off was driven ostensibly by concerns over China’s slowing economy, currency devaluation, and distressed commodity prices, but this doesn’t fully explain what happened. China’s challenges aren’t new or even sudden. The economy has been slowing for some time; analysts have expressed concern about inflated prices for a while, and the currency devaluation was within a narrow band that restored the yuan to a more realistic level rather than being the drastic blow to U.S. imports that people think it will be. As for commodity prices, oil has been falling steadily for a more than a year.

The sell-off was at least as much the result of sheer, irrational panic as a careful consideration of macroeconomic factors. Sure, high-frequency trading and the volatility it can precipitate undoubtedly made things worse but seller psychology played a big part.

The perfect example of this is Netflix (NFLX). Even though the streaming video giant has announced a valuable agreement with SoftBank (TYO) for its Japan expansion next month and its prospects remain good, its stock was hammered. Netflix may face challenges when it enters China due to the soft economy, but that market is already fraught with difficulties. So macroeconomic factors can hardly explain why investors were suddenly so bearish on the company.

 

This is even more mystifying if you consider that the majority of Netflix’s business is conducted in the U.S., where the economy is relatively strong and improving. The only logical explanation is that the run on Netflix’s stock was the result of investors racing blindly for the door after European and Asian markets yelled “fire!” As the day progressed and the panic spread across major news outlets, the more investors rushed to unload their shares and stem their losses, which pushed the needle down even further.

Tuesday was the exact reverse. Buoyed by stronger European markets and a Chinese stimulus in the form of lower interest rates and relaxed reserve requirements for banks, and exhausted from Monday’s carnage, U.S. investors sought relief. That sentiment helped prop up the markets right from the start and, not by coincidence, shaped media coverage. The more confident people felt reading the news and analyst prognostications, the more they rushed back in to buy stocks. Netflix, which had started Monday at about $89 per share, opened the next day at almost $108.

But the fact that the euphoria was so short-lived signals what could happen in the weeks ahead.

The reason that investors quickly lost faith in the so-called recovery was because there was nothing tangible to back it up. Just as the panic a day earlier was irrational, so was the hope that followed. Despite the Chinese government’s short-term stimulus to encourage buying and stabilize the country’s stock market, the long-term impact on its economy is yet to be seen, and it’s that which will determine how much China’s slowdown will impact the rest of the world. As if in confirmation, Chinese equities fell again Tuesday. The price of oil rose a little but is still at a multi-year low.

 

Ideally, things should settle down now that one cycle of panic and hope are over. But the extreme investor behavior of the last few days, the memory of Black Monday, and the fact that the global problems that started it all haven’t gone away, mean that the U.S. stock market is a powder keg that could easily erupt again. All it would take is another catalyst, like perhaps the Federal Reserve surprising U.S. markets by raising interest rates sooner than later; a decline in corporate earnings in the third quarter; or some other unexpected international crisis to spark another panic.

That’s not all bad, of course. If you’re an astute investor with an appetite for some risk, watch for that next big dip. It may be scary, but it will contain some great buying opportunities and some handsome profits when the market comes back to its senses. Again.

S. Kumar is a tech and business commentator. He has worked in technology, media, and telecom investment banking. He is not an investor of Netflix or Softbank.

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