Stock market crashes as well as crashes of other assets and economic/fiscal crisis happen regularly. So forecasting that another crash will soon happen is not that difficult. It will happen. That said, major market recoveries do happen as often as crashes.
The coronavirus outbreak and the fear that it could become a pandemic initially crushed stocks in spring 2020. The Dow fell close to 10.000 points from its peak on December 28, 2019, up to its low on March 23, 2020. Since that it has recovered nearly all of its losses trading at or close to peak levels at the end of October 2020.
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The doomsters are predicting a second leg of the downturn to be imminent while the optimists see a continuation of the bull market ahead, once the effects of the pandemic have been overcome.
Financial market crashes are frequent
Stock market crashes are devastating bursts of market downturns that can last a single day only (flash crashes) or lead to full-fledged bear markets taking months or years. They turn paper millionaires into bankrupt individuals living hand to mouth.
A stock market crash occurs when high-profile market indices, like the Standard & Poor’s 500 or the Dow Jones Industrial Index, top out, as investors turn from buyers into sellers instantly. Any market day where stocks fall by 10% or more is considered a market crash, and these crashes have happened on a fairly frequent basis, historically.
Historians differ in tallying the actual number of stock market crashes throughout history, but in the U.S., there have been at least six major market collapses recorded, where the stock market lost over 10% of its value. Sometimes crashes are related to trading computers going wild, sometimes they are related to asset bubbles, overleveraging, or outside shocks to the system.
In more recent times, flash-crashes have become a short-term threat to the marketplace as an unintended consequence of rapidly growing dependence on technology and algorithmic trading. A flash crash is defined as an extremely rapid decline in the price of one or more commodities or securities, typically one caused by automated trading.”
With market participants relying more and more on technology in the last 20 years or so, and the popularity of quantitative and algorithmic trading growing exponentially, flash-crashes have become a threat to financial market stability. Even though technology and the people behind it take the blame, there is one commonality between the following examples of major flash-crashes – market duress. Not necessarily major duress, but enough that a significant imbalance can occur in the vacuum of liquidity. A bevy of orders from one side of the market comes in and simultaneously the other side effectively steps away and just like that you have a major air pocket. These air pockets, or liquidity vacuums, result in a sudden spike in price. And while they are only temporary the financial impact can be enormous for those caught in these unforeseen events.
Five steps of a bubble
An asset bubble occurs when the price of a financial asset or commodity rises to levels that are well above either historical norms, the asset’s intrinsic value, or both. Usually, there is a narrative linked to that rise which tells that this time the extra valuation is justified because the underlying rules of the system have changed – either for good or at least for longer. This leads to the belief that the intrinsic value of an asset has skyrocketed, meaning the asset is now worth much more than it fundamentally used to be.
The economist Hyman P. Minsky developed a theory to explain the development of financial instability and its interaction with the real-world economy. His book, “Stabilizing an Unstable Economy (1986)”, is considered a pioneering work on this subject. Minsky identified five stages in a typical credit cycle–displacement, boom, euphoria, profit taking and panic. Although there are various interpretations of the cycle, the general pattern of bubble activity remains fairly consistent.
1. Displacement: A displacement occurs when investors get enamored by a new paradigm, such as innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in the federal funds rate from 6.5% in May 2000 to 1% in June 2003. Over this three-year period, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to historic lows of 5.21%, sowing the seeds for the housing bubble.
2. Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.
3. Euphoria: During this phase, caution is thrown to the wind, as asset prices skyrocket. The “greater fool” theory plays out everywhere.
Valuations reach extreme levels during this phase. For example, at the peak of the Japanese real estate bubble in 1989, land in Tokyo sold for as much as $139,000 per square foot, or more than 350-times the value of Manhattan property. After the bubble burst, real estate lost approximately 80% of its inflated value, while stock prices declined by 70%. Similarly, at the height of the Internet bubble in March 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.
During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.
4. Profit Taking: By this time, the smart money–heeding the warning signs–is generally selling out positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise and extremely hazardous to one’s financial health, because, as John Maynard Keynes put it, “the markets can stay irrational longer than you can stay solvent.”
Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot “inflate” again. In August 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value their holdings. While this development initially rattled financial markets, it was brushed aside over the next couple of months, as global equity markets reached new highs. In retrospect, this relatively minor event was indeed a warning sign of the turbulent times to come.
5. Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply.
On the next pages, we take a close look at the biggest stock market crashes and asset bubbles throughout history. On the following page, we cover the crashes up to the 21st century. We start with the so-called tulip bubble in the 17th century. On page 3 we take a close look at some of the crashes of the 21st century; those that have occurred in the first 10 years, while on page 4 we cover the disasters from 2011 until 2020.
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