Cuases of Stock Market Crash Today
The most dangerous words in finance is “its different this time”. Markets are driven by psychology as much as the underlying value of the companies. The names change, the circumstances change but fear and greed is constant in the stock market bubbles and crashes throughout history.
Stock market crashes happen more often than investors realize. It is a key flaw for those that believe that the market is efficient to justify that the market is worth a certain amount one day and suddenly 10% less a day later and much less years later.
Steps in the market cycle
The decisions and run up in the market leading to a crash are always the same. It starts with a market driven by fundamentals. There is always a just reason (technology taking over the world or financials can sustain high ROE with leverage). Greed then takes over as those that bought into the story start to putting money in the markets. Then the market does what it always do, overshoots on upside.
Investors become blinded by the original story and fundamentals becomes lees important. The story become gospel, prices becomes detached from reality and current trend is extrapolated into the future. Price then becomes the story. The belief that markets never goes down takes over and that it is different this time.
And then there are no more buyers when everyone that could have bought and have bought into the market. Now as the stock market is valued way beyond what the fundamentals can be justified. The long crash to reality starts and fear begins to takeover.
List of major market collapses in the last 3 decades
List below are the most recent crashes, the key story that drove the market, the time and range the market took from peak to rock bottom.
- Global 2007/2008 – US market benchmark S&P 500 peaked in October 2007 at 1548 and bottom in 2009 at 666. Key cause – debt fueled binge leading to over leveraging.
- Nasdaq in 2000 where the NASDAQ 100 peaked in May 24, 2000 at 4691 and bottomed October 9, 2002 at 802. Technology taking over the world.
- Nikkei in 1989 reached peak of 38,957 before bottoming in 2009 at 7054. It took 2 decades for the index to bottom. Japan taking over the world.
- Black Monday 1987 October 19 where the S&P 500 fell 22.6% in 1 day. Portfolio insurance where selling led to more selling.
The list does even include the crashes in the Nifty Fifities (you have to own growth stocks) or the period of the roaring twenties that led to the depression (US taking over the world).
We as value investors should not care about the overall fluctuations in the market but should be aware of the broader macro trends and where we sit in the cycle. We aim to find undervalued securities with a strong margin of safety.
Booming share markets actually make our life more difficult as it is more difficult in finding value. This is offset by the aftermath of market collapses where everything is sold indiscriminately it can be considered some of the best time to buy and make purchases of a lifetime.
Last large market fall
The last major economic crisis was preceded by a financial crisis. It placed a key tenant of the efficient market hypothesis to the test. Unlike the Nasdaq bubble, the market in 2007 was not overvalued or in bubble territory. The collapse in the US housing market coupled with over leveraging of the financial companies and consumers was the main culprit.
The US consumer saw to offset the limited income growth in the last decade by borrowing to sustain spending. The borrowing was supported by their equity in the home. The unsustainable spending leading to over leveraged consumer balance sheet means that any minor change in house prices had a large impact.
As we now know, house prices do not go up forever. When the housing market slowdown and the higher adjusted rate mortgage rates kicked in, the economy came to a standstill.
The Federal Reserve unleashed a number of policies aimed to support the economy, unparalleled since the last depression in the 1930s. Nearly a decade since the last rate cut, interest rates are still at record lows.
US government bailed out the banks which were considered too big to fail. Large parts of the population saw that while the little guys saw little or no income growth. The rich got tax cuts and bailouts. The political implication of that decision is still felt today in the run up to the 2016 election. See the US Congress report on the crisis for more detail.
Most major economies around the globe are still recovering from the last economic crisis. Total US employment only reached past the pre crises high only in the last few years.
European Union failed to clean up the banks post recession is still struggling economically. By implication this is the main weight on the Euro vs Dollar exchange rate.
China Stock Market Crash – latest market exuberance
The Chinese stock market is the latest market that saw an unsustainable sharp rise and fall. It was driven by policy makers whom believed a strong stock market is required as part of the shift to consumption driven economy. The implicit support of a strong stock market by government caused the retail investors to flood the market with many buying near the top.
The CSI 300 index peaked at 5353 and made a bottom at 3042 all in a span of 6 months.
The list of other market crashes highlights that sometimes it takes years for the market to reach the final bottom where all the excess has been washed away. Given the lowest point so far is only within 6 month of the peak. The experience from above shows that it might be awhile before we know if this is the real market bottom.
Crashes do not happen just in share markets
Any asset that can be bought and sold can become a bubble market. After all the one of the first financial bubbles was in dutch tulips. Even we made a forecast Sydney real estate market to be in this category at one point. Given the record low interest rate and upcoming glut of apartments we consider there is more downside risks than rewards in owning Sydney properties.
The record low interest rates have driven record highs in a number of asset classes. For example Australian commercial property values have reached highs it saw just before the last financial crisis.
Perhaps looking back few years from now the asset that is potentially with the greatest risk to fall from where it is priced today is the bond market. Short term interest rates are at record low but the bond market is pricing in the event that the long term interest rate will be near zero across a large number of economies for decades to come.
Forever is a long time and as unforeseen events causes people’s expectation to change so will asset prices. Any change in future expectations of interest rates will mean the current holders of long term bonds are set for a large fall in capital value. This is usually offset by interest on the bond but if you bought at near zero rates, your income return will be near zero.
Just as in current older generation sees in the 18% interest rates in the 1980’s as the generational high in interest rates. Perhaps we will look at today from the future to see as the point where interest rates made a generational low at near zero.