MAJOR STOCK MARKET CRASHES
Those who do not learn from their mistakes are doomed to repeat them
In the stock market, we have had several instances that support the fact that many people do not even understand the market but they invest anyway just because of the hype.
The Market is everything but Reasonable. Sometimes, this has caused some major problems.
Therefore, we should study about the worst crashes in the market and understand what caused them and learn from them.
1)THE CRASH OF 1929 AKA THE GREAT CRASH:
This crash was considered the worst crash of the 20th century. During 1920–1928, the US economy rose drastically. In the early 1920s the development of more and more electrical appliances was increasing and their sales were doubling every couple of years. The electrical based companies were opening plants in several parts of the country.
Moreover, easy loans, low interest rates and installment buying was helping in the economic boom since the early 1920s. The farmers were borrowing loans to buy mechanized goods to surge the production.
Good industrial growth caused the stock market to rise constantly. People were mortgaging their homes to invest in the market because why not, it was a “sure thing” to make money in the market. So many investors, even those who did not had any prior knowledge of investing invested in the market on a margin due to which the stock prices were getting overvalued. By August 1929, the stock prices sky rocketed and eventually exceeded the actual value of the company. This is how an over evaluation bubble was created in the market.
Now the problem had started. Due to industrialization, the production capacity had increased several folds which caused the market to flooded with cheap agricultural goods making it difficult for the leveraged farmers to make money. To discourage borrowing on the margin, the government raised the lending rate which ironically had a knock-on effect.
The central banks in Europe now felt that they had to match the new rate of interest, that sent many of the countries still recovering from the first world war into recession. At the same time in the US, an agricultural drought had slowed down the economy. Even after that people did not stop investing in stock market and there came a time when the value of the market had almost doubled and the stock prices of the companies did not justify their earnings.
This bubble began to burst in August 1929. The value of the market started to reduce, inducing fears in the minds of the investors, thus they started taking out money which resulted in the further fall of the market. By October 24th 1929 the market had dropped by 23% and the DOW JONES INDUSTRIAL AVERAGE(DJIA) did not hit bottom till mid-1932. Thus, October 24th 1929 was also known as Black Thursday. On this day alone the DJIA fell 11% and by October 29th the prices fell by 90%.
All the investors suddenly stopped investing in the market and as the companies did not get any investment, they had to shut their plants and declare bankruptcy. The banks could not get their loans back from these companies and due to unemployment, people started taking out their savings from the bank. Due to this lack of credit, the banks were not able to offer a corporate bailout to the companies and the economy kept on declining. Banks were not able to give money to the depositors and thus about 8000 banks in the US declared bankruptcy. This way the US entered a recession.
The president of that time, Mr. HERBERT HOOVER did not do anything to reduce high prices of the commodities. So, the people started using the cheaper imported goods. To stop this, the government imposed high tariffs on import that led to decline in the international trade and the condition worsened sending the country from recession to the GREAT DEPRESSION of 1930s that lasted 10 years.
2)THE CRASH OF 1987: HIGH EVALUATION BUBBLE:
Since the Great Crash of 1929, this is considered the worst drop of stock market in one day. On 19th October 1987, the DJIA dropped more than 22%, more than 500 points, almost double of what dropped on the Black Thursday. The severity of the crash sparked fear of extended economic instability.
Since the early 1980s, the US stock market was increasing at a rapid speed and between January-September of 1987, the market increased almost up to 30% of its value.
The share prices of the companies were increasing very rapidly but their performance was not that good which raised questions about the company’s evaluation and thus an overvaluation bubble was formed.
In the month of October, the market had already fallen twice with a very rapid speed which induced fear in the minds of the investors that the bubble might burst anytime soon.
So, the institutional investors started using portfolio insurance, by shorting the stocks, to minimize their losses if the stocks lose their value. This increased the pressure to sell in the market which was one of the major reasons for the fall of the market.
The other major reason was the trade deficit numbers that were introduced that year, that were hugely concerning for the investors. The trade deficit that year increased from $93 billion to $136 billion that indicated that the economy was in trouble. This added to the selling pressure further more.
The last reason for the crash was the margin-call. On October 19th 1987, often referred to as Black Monday, the DOW fell by 22%, due to which the margin-call for several investors was hit and their brokers sold off their shares.
So, the crash of 1987 was not due to any economic crisis but largely due to the overvaluation of companies.
After the crash, the market was still dropping. This was the time when intelligent investors started to invest money again in companies. Warren Buffet bought 6% stake of coca cola that year.
3)THE DOTCOM BUST: 2000
The main reason for this crash was the rapid development and commercialization of the internet
In the early 1990s, the internet was not so much user friendly, and only the techiest people could make use of it properly. This was the condition until the release of MOSAIC. It was the first browser that was able to display images and all along side the text, and was very easy to use and very user friendly. But the real gold-rush came in late 1995, all thanks to a company called NETSCAPE communications, a company with its own interactive web browser as well as a NAVIGATOR.
The founders decided to cash in on their company’s success by listing it on the stock market. This started a havoc in the stock market. First hour of listing, the value of the share price just doubled. It was just a matter of minutes that the market capitalization of the companies was pushed to almost $2.7 billion on the first day.
This attracted a wave of entrepreneurs and investors. This ultimately led to all the businesses coming online. More and more investors were drawn to the market seeing the returns. People were throwing their money on anything that had a “dotcom” after their name. Some people didn’t even know the basics like the evaluation and the p/e ratio of the company but they had to invest out of the fear of missing out.
Many companies added a dotcom after their name just to increase their amount of profits. But it wasn’t a problem for them as investors had decided to overlook the past outdated metrics like profitability and evaluation. Even the presence of a bug called Y2K did not affect the sky rocketing NASDAQ index as the new technological developments hyped the fever further more.
Thus, a bubble was again created. On March 10th 2000, the NASDAQ index hit 5000 points, a bubble 200 times the size of actual underlying earnings. Then on March 13th 2000, Japan, the heaviest user of tech, announced recession. It was the second largest economy of the time, so it sparked a fear that the decrease in demand might crimp the earnings for tech companies dependent upon exports.
So, the investors thought if the companies could survive without capital, and then stopped investing money in these companies suddenly. Soon tech companies found themselves burning through cash. Within months the companies that were worth billions of dollars declared bankruptcy, many frauds came into light and the US announced that they are in recession.
The trembling market’s condition worsened by the terrorist attacks of September 2001, and the downfall of the market accelerated. By the end of October 2002, the market had lost $5 trillion since the NASDAQ peaked, that is 1114 points and a decline of 77.9%.
While most of the companies faded out for good, some like AMAZON and EBAY prospered while others reduced to a shadow of what they used to be. Thousands of jobs were lost and it took almost 15 years to fully recover from the losses.
4)THE GREAT CRASH OF 2007: HOUSING BUBBLE
Since the great depression, this crash was considered the worst. Due to globalization many countries had also started investing in the investment banks of the US and due to the low interest rates in the banks, it was easier for countries to ask for loans to overcome financial crisis.
Since the crash of market in 2002, the investors started moving their money into the housing market, so at the same time as that, housing market was on the rise.
Glass-Stegall Act: this act was first formed in 1933 to separate investment banking from retail banking. This act was abolished in 1999 that became one of the major causes for the recession of 2008. When countries borrowed money from the investment banks of the US, like AIG, they were provided with CDOs as insurance. CDOs were actually bonds made from the mortgages those came mainly from the housing market as collateral to the commercial banks for house loans. The abolishment of this act therefore created problems as the mortgages given as collateral to the commercial banks were given to countries as CDOs by the investment banks
In the housing market, people could get loans on a low interest rate by keeping some kind of mortgage as a collateral. This wasn’t a problem for the prime borrowers, that is people who actually had the ability to return the loan borrowed in time. But as more and more countries invested in these investment banks it meant that more loans had to be given out by the retail banks in order to make more CDOs.
So, the commercial banks started giving out more and more loans to sub-prime borrowers, that is people who might not be able to return the loan back.
Here credit default swap or CDS came into play. Loans were being given out randomly to anyone and that too without insurance. And the CDOs were being given a good rating, that didn’t not have any value. The main problem started when the sub-prime borrowers which were in the first place not even qualified for the loan, they stopped paying their loan.
Due to this the commercial banks started acquiring the houses of these sub-prime families. As more and more sub-prime borrowers stopped paying their loans, there became an abundance of houses with the commercial banks. Due to this, the value of the housing market, which was earlier rising at a steady state, started to come down.
This induced fear in the minds of the investors of the housing market. So, the prime families also started to sell their houses as the value was depreciating. So now the loans that were coming to the commercial banks from the prime families also stopped. Therefore, all the houses became a non performing asset for the banks.
Due to this the people who actually wanted loans could not get them as the banks had little or no credit for lending the money and so the economy came to a standstill. Unemployment rate reached almost 10% in US.
This is how the housing bubble burst and this caused problems as the countries that invested in the banks started to realize that their CDOs were actually failing as the investment banks did not have enough assets to pay the money back.
On 15th September 2008, LEHMAN BROTHERS, one of the largest banks in the united states declared bankruptcy. Even the Federal Reserve couldn’t offer them a corporate bailout and eventually on 29th September 2008, the DOW JONES INDUSTRIAL AVERAGE had a record-breaking drop of 777.68 points. By March 2009, the market had lost 54% of its value since October 2007.
As the banks failed, many countries like Iceland also went bankrupt.
