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Panic Selling and The Federal Reserve

Feddy Warbucks does it again

I often stay away from market news, data, and commentary as it represents more noise than signal for purposes of effective financial decision making. Most of the time it’s like the rest of the news cycle—just finding things to talk about to generate clicks, views, etc. There are just no meaningful takeaways. It’s more entertainment than information.

Then there are times like this. 

The uncharted waters for our society have created chaos in the financial markets. Like every other crisis we have huge drops in financial assets and panic selling. That’s to be expected. 

Luckily, the Federal Reserve can step in like a rich uncle whenever we get ourselves in trouble.

The fundamental purpose of a market is to provide a free exchange to buy and sell. If the market is efficient, it will create a fair price. In this case, that "something" is a bond.

A bond is a loan from an investor to an issuer (business, government, etc.) where the issuer pays a certain level of interest for a period of time, and then all principal upon maturity. 

You give Apple $1,000 and for ten years Apple pays you $50 (5%). In year ten, they give you your $1,000 back. 

What happens when you need $1,000 in year five? In a strong market you could sell that bond for somewhere close to $1,000.

But when panic hits the market, there’s an immediate shift in the normal balance because everyone becomes sellers. Good bonds are selling $950, then $900, then $800….. 

Soon after, a bunch of bond holders that didn’t want to sell realize their bonds are worth less on the open market. If the value of the bonds have dropped by 20%, an investor might say “I might want to sell this before it gets any worse—I’d rather have cash”. Alternatively, they might say "these companies can't pay me back--this bond is worthless. I should sell!" 

This mentality creates a panic scenario that exacerbates the price drop. More sellers, fewer buyers, further crashes.

Finally, there’s a “run on the bank” where the bottom falls out of the market. If it gets bad enough, the market fails. 

Enter…The Federal Reserve

To prevent the world from collapsing, the Fed steps in to become the market. The Fed can provide the needed liquidity for sellers. Once would-be panic sellers see that there's still an opportunity to sell, they calm down. 

And then everyone can then behave somewhat normally. The Federal Reserve is there to reassure investors that if or when they need to sell, there will be a willing buyer. This calms the panic and restores market stability.

In some ways this is an artificial scaffold to the market which goes against the idea of markets totally free from government influence. A pure capitalist might say "let the market die." 

On the other hand, it doesn't make sense for many good investments to become worthless because of human hysteria. 

The thinking behind this is that we can afford to lose a few market participants, but we can’t lose the market. The market is something that works well most of the time and provides benefits that society needs. Many people will suffer in hard times, but we can’t lose the entire system or infrastructure.

If core assumptions (sufficient amounts of willing buyers and sellers) about the system or infrastructure break down, we have to find ways to substitute for them.

The market is not just liquidity for individual investors, but all of commerce. Without capital freely flowing around our society, there would be consequences well above those of a normal recession or depression.

In some ways, the Federal Reserve is like a power generator when nature knocks out electricity. You can flip a switch to a fossil fuel-powered generator to power core systems in your house to keep living normally.

Don’t Be A Panic Seller…Be A Buyer

What many don’t realize, because they’re so nervous about the value of their investment accounts, is that panic selling scenarios can create once in a lifetime buying opportunities.

A panic in the bond market can provide great potential to buy healthy bonds from strong companies at a nice yield. 

So long as the issuer is not in default (like Apple), the bond investor will recover their principal. Imagine buying a bond with a par value of $1,000 and 5% yield for $800 due to panic. Seems like easy money, if you can stomach it. 

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