Stock Market Crash: Will It Happen Again?
Historical facts and figures suggest that a bullish and growing economy is always followed by a bearish market trend. On an average, if the economy has flourished for 6-10 years it is normally followed by a period of negative growth of 6 months to 2 years. This is when a rapid decline in the prices of stocks is witnessed in the market what is known as a stock market crash. Although the reasons for a crash are not exactly known, in general it is seen that rising stock prices over an extended period increases the optimism of the investors. They come under the illusion that stock prices will always rise and will never fall. The price of investments and real estate becomes sky-high. People start spending more than they earn and investing on credit.
This economic situation causes the price-to-earnings (P/E) ratio of a stock to exceed its long-term averages. The investors indiscriminately use margin debt. This leads to an enormous percentage decline in market index over an extended period a crash is caused by a combination of social phenomena and external economic events. This is because during a crash, investors have a tendency to sell off their shares all at once and do not follow the degrading economic conditions.
The stock market crash of 1929 followed the “Roaring Twenties” of 1920s. The Dow Jones Industrial Average soared, creating an economic boom. On October 24, 1929, the index dropped by 38 points. Similar crash happened in 1987, where the index dropped by 508 points. Financial markets fluctuate constantly creating new opportunities for investors. These crashes provide investors with the reality that stock trading can be a risky business and must be done with care and caution. Financial markets depend on computerized systems for stock prices during trading. Breakdown of the network may lead to a panicky situation for investors. All this and more had contributed to the economy crash of the 1920s and 1980s.
In 2008, the bankruptcy of Lehman Brothers indicated another period of the stock market crash. The primary reason for this was the failure of financial institutions. Securities of packaged subprime loans and credit default swaps issued led to a huge credit crunch and economic turmoil resulting in a crash.
The grave consequences of a crash are reduced consumer confidence in the growth of the economy, increased unemployment, reduced government budget due to low tax revenue, reduced demand leading to reduced wage inflation, low profitability of businesses, etc. Other effects include increase in the number of repossessions by homeowners, reduced percentage of mortgage lending, reduced credit for consumers, decline in the pension schemes offered, salary cuts for employees, etc. However, on a positive note, this may be an opportunity for investors to buy shares at low prices and gain profits in the long term.
Protecting Your Assets from a Market Crash
• Lower your exposure. It’s that easy. Take some cash; park it in a bank CD. Not for yield per se, just for protection that pays a tad bit more than stuffing it under your mattress.
• Make sure whatever you are holding is diversified – for industry as well as direction of the market. In other words, if you buy only stocks, own shares of an exchange-traded fund (ETF) that gives you shorting exposure (an ETF that benefits if the market falls). Be sure to keep upside exposure as well. Timing an economic crash is nearly impossible, so you want to benefit from shares drifting higher.
• Sit idle. Markets are going to be volatile. There will be times it looks like the market will go higher forever, but it can’t… and won’t. Don’t go all in. Maintain your short exposure. Same goes for a market dip. Don’t dump your long-term holdings. Strong stable stocks that you plan on holding for years can weather the downturn. You will have paper losses, but your short exposure should offset that.
• Wait for a bottom. Of course, predicting a bottom is impossible. Pundits will always try to call it, and it might be on their sixth, seventh or eighth try before they get it right. So wait for the market to actually form a bottom and start to head higher. Then ease back in with some of the cash you are parking on the sidelines today.
Trading After a Stock Market Crash
When the market crashes, many traders are bewildered, because they are not familiar with a crash, or might have just started to trade. So for these traders, what should they do?
When stock market crashes the first thing that most experienced traders do is to seek refuge and safety. In the exuberance of a buoyant market, traders and investors do skip quality for the benefit of fast capital gains. In the process, they go for all sorts of stocks and shares, even those that do not meet stringent selection criteria of bringing in fundamental value over the long run. As long as they appear cheap, poorer quality stocks are purchased with the hope of rising further in prices, which they do during a bullish market. But once the market has crashed, it is the fundamental quality of the stock that is important to shore up its falling price.
Once a stock market crashes, there is a flight back to quality stocks.
Experienced and savvy traders exchange poor quality stocks with good quality stocks or blue chips. These established stocks possess good earnings, and generate good dividends and are the first to rebound when the market stabilises after a crash.
There is a bath tap analogy. Like water being let into a bath tub when you are taking a bath and water is being filled into the tub, the dirt and scum rises to the top, with better water quality at the lower portions of the bath tub. So during a bullish market, it is the lesser quality stocks and shares that go up first, with the blue chips the last to move upwards in price. But once the stopper is unplugged, it is the better quality water that flows out from the bottom, leaving the scum and dirt at the upper portions being the last to flow out.
Similarly, during a crash, just like the water that gushes out of a bath with the stopper unplugged, the experienced traders and smart money quietly sell out on the better quality stocks earlier on, leaving the uninformed traders holding on to stocks of poorer quality when the market crashes.
It is those experienced traders who have sold out the better quality stocks earlier before the full aftermath of the crash is seen and felt that are now in the best position to move back into the better quality stocks during a crash, and at lower prices.
During and after a market crash, go for quality and you will be well rewarded many months down the road. Adopt trading techniques that are proven to help you trade during a bearish market and you will do well.