Stock markets crash, rebound, decline for extended periods, and climb for long durations. Sometimes the fall and rise are steady, but the past year was odd. Stock markets were wild, yielding a scary emotional roller coaster ride. In this article, after peeking at the present, I examine three prior market crashes to deduce lessons and suggest how we might stay unscathed.
Meanwhile, let’s be calm. This will pass. Most of all, we want to maintain previous well considered investment positions. For instance, the chart below shows value stocks’ (they trade below inherent value, which ignores “market noise”) steady performance versus growth stocks (stocks expected to grow sales and earnings faster than the market average) this year. Mega growth stocks plunged — Netflix 69%, Meta (Facebook) 38%, Amazon 30% and Microsoft 17% — but some value stocks had lesser declines while others like Enbridge and Fortis rose.
Protracted low interest rates, cheap money, excessive borrowing, inflation, rising interest rates, and the pandemic led to panic; there are no shortages of issues to heighten this fear. The war in Ukraine, high gas prices, ridiculously high housing prices are a few examples that add to these hard times.
Stock markets hate uncertainty and the investing public’s behavior is illogical because they use the stock market like a casino.
After the memorable stock market crash in March 2020, the steady rise in the market defied effects of the pandemic, lockdowns and firms’ fundamentals.
Now, the million dollar question is, are we seeing the start of a major market crash? Nobody knows because fear has driven behavior for some time and many bargains exist today. Will investors pounce on these and push prices up? Today, May 12, CNN’s Fear & Greed Index shows extreme fear and for the past year it’s been below neutral. Excessive fear drives share prices down, and the herd mentality that pervades the market leads people to sell when they should hold or buy, and vice versa. Will folks stop charging for the exit?
Brokerage Margin Accounts Key to Trading
The Financial Industry Regulatory Authority (FINRA) is a US body that regulates financial professionals and organizations. One of its roles is monitoring margins (loans to buy shares) in brokerage accounts. October 2021 balances caused concern when margin balances jumped 73% from March 2020 to $935.9 billion.
Rising margin debt, per se, isn’t the issue. The size of the increase is, as it’s rare for a 60% or more jump in a single year, as in 2021. Since 1995, twice when margin debt soared at least 60% in one year, the stock market crashed soon after. Then again, in January, Warren Buffett’s market metrics comparing the stock market’s valuation to the size of the economy stood at 211%, pointing to an imminent market crash.
Lessons From Prior Market Crashes
The past is a poor future predictor, but we can learn from prior market crashes such as those in 1987, 2000, and 2008.
Stock Market Crash 1987: Black Monday
The Dow Jones Industrial Average (Dow) reached a new high on August 25, 1987 at 2722.44 points. Then, on October 19, 1987, it dropped 508 points or 22.6% in a single trading day — a 36.7% fall from the August 25, 1987 high. Global markets crashed, too.
After Black Monday, regulators and economists identified some probable causes. They noted substantial foreign investment activity in US markets hiked stock prices, and they identified the popular portfolio insurance as an important cause: The Securities and Exchange Commission (SEC) concluded, “futures trading and strategies involving the use of futures were… “a significant factor in accelerating and exacerbating the declines.”
Regulators found structural market flaws relating to stocks, options, and the futures markets that worsened Black Monday losses. They introduced circuit breakers requiring exchanges to stop trading when the S&P 500 stock index falls seven, 13, and 20 percents. The pause is to allow “the ability to make informed choices during periods of high market volatility.”
Stock Market Crash 2000: Corporate Corruption Era
The economy boomed between 1992-2000. So did corporate corruption, as firms fabricated results to maintain high stock prices. Meanwhile, major conflicts of interest existed as rating agencies gave false positive ratings about affiliated firms to allow them to raise funds. Internet-based companies (Dotcoms) popped up everywhere. Companies had no earnings or business models, but investors bought their stocks because that was fashionable. Meanwhile, people got rich and assumed prices would never fall, even though many firms had no intrinsic value. And the internet enabled online trading and the birth of the day trader with almost no experience, thus cementing the use of the stock market as a casino.
To fix many issues contributing to the crash, the government passed laws regulating day traders, financial institutions’ conflicts of interest, CEOs and CFOs accountability, and accounting transparency.
Stock Market Crash 2008: Sub prime Mortgages
The 2008 market crash was avoidable but inevitable because of government action. Repealing the Glass-Steagall Act of 1933 and later enacting the Commodity Futures Modernization Act exempting credit default swaps and other derivatives from regulations, provided the basis for the crash. And with corporate greed and corruption rampant, these changes led to the subprime mortgage debacle and the major housing crash. The Final Report of the National Commission on the Causes of the Financial and Economic Crisis of the United States notes between 2001 and 2007, mortgage debt rose almost as much as accumulated historical mortgages.
Government made several changes following the 2008 crash including the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010 that brought sweeping reforms to the U.S. financial sector. And it introduced the Consumer Financial Protection Bureau (CFPB) to help monitor and protect the financial interests of American consumers.
Since January 3, the roller coaster has taken the Dow down 15%. Are we headed for a major crash? Many factors exist that suggest we could be. But investors’ irrational behavior leads to the market functioning as a casino, so we don’t know. What can we take from prior market crashes to help understand likely market direction? Not much. To be sure, we don’t need more regulations, but regulators must do effective jobs. Fear will continue to prevail and affect investors’ behavior because so many challenges exist in the political and economic spheres.
Meanwhile, let’s remember we lose only when we sell, not when prices fall, and although the market is down, some sectors are immune and are resilient to today’s fluctuations, for instance, healthcare, consumer staples, and utilities. Ensure you have an investment goal; validate it and unless it needs changing and the fundamentals of businesses in which you invest change, stay with it. This will pass.
© 2022 Michel A Bell