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When the World’s Best-Performing Stock Market Takes a Dive

Taiwan boasts the best-performing stock market of any MSCI index in either the developed or emerging-market universe since the beginning of 2020. This week a sharp selloff brought it close to losing that crown.

The plunge is a classic story of exuberance and leverage, with lessons for investors in the U.S. and beyond.

The immediate cause was apparently Taiwan’s worst outbreak of Covid-19 since the beginning of the pandemic. Sixteen locally transmitted cases blotted a largely stainless record of keeping the island basically quarantined from the rest of the world.

The market boom since March last year has encouraged ever more investors to take on margin debt, which has risen to its highest level in around a decade. Margin debt magnifies selloffs, because investors whose brokerage accounts are displaying losses are asked to post more collateral—a margin call—and have to sell more stocks to raise the cash in response.

That explains the breadth of the selloff on Wednesday in particular. At one point, the Taiex index was down by around 9%, taking with it pretty much every company regardless of its exposure to the domestic economy. Take the case of Taiwan Semiconductor Manufacturing Co., the world’s largest contract chip maker, which has been an enormous beneficiary of the massive demand for semis world-wide. It nonetheless tumbled by a similar amount.

Of course, Taiwan’s small number of Covid-19 cases, while bad news for residents, has very little bearing on the performance of TSMC, which makes a little over 60% of its revenue from U.S. customers. Even the slightly-less-than-10% of revenue it makes in Taiwan is likely an overestimate, since much of that will be sales of chips to Taiwanese companies themselves exporting an end product overseas.

But that won’t stop its share price plunging, purely on flows from investors who need to cover themselves, with fewer would-be buyers on the other side. John Maynard Keynes likely never actually said “the market can remain irrational longer than you can remain solvent,” but the sentiment is correct.

Taiwan is hardly the only place where leveraged equity purchases have risen. The U.S., India and Korea are all among the countries where margin debt has climbed, as it tends to do when markets are rallying hard. That carries the risk of messy selloffs, which won’t discriminate between companies actually seeing difficulties and those not affected by the cause of the drop.

Write to Mike Bird at Mike.Bird@wsj.com

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