The stock market is as unpredictable as the ocean on a stormy night. It is tempestuous and temperamental and can rise and fall in the blink of an eye.
I am sure you have all heard warnings and tales of the nature of the stock market. History is dotted with examples of how unpredicted crashes have cost people all their life savings. There are also stories of how people make millions on successful trades.
The world we presently inhabit is headed for an unexpected recession. Much like Mother Earth shaking off years of accumulated pollution, the recent coronavirus epidemic has taken the world by a storm. As there is no known cure or vaccine for this disease, the only way we can combat this spread is through isolation and quarantine.
Easier said than done, of course.
The economic impacts of a prolonged lockdown period and cessation of business activities are too wide to imagine. This epidemic is imposing an unbearable strain on the global economy, and catapulting us towards recession.
In this helpless scenario, the one thing we can do is arm ourselves with information. We have to understand what causes stock market crashes and how we can combat them.
The most recent stock market crash was the one which led to the 2008 recession. This was caused by the collapse of the bubble in the US housing markets, and the ripple effects of the same dragged all other major economies into recession.
However, as this is the most recent crash, it has been picked apart and analysed to death. The 2008 recession has been a favourite topic for economists and policymakers around the world, and we are all aware of the glory details of this event.
So let us cast our memory back a bit further, shall we?
One of the most noteworthy stock markets crashes in recent history is the one that occurred in 1987. In fact, the day it happened, October 19, is fondly referred to as the Black Monday.
The moniker should be clue enough. It instils a sense of impending dread and anticipation for what follows.
Black Monday saw the US markets fall by more than 20% in a single day. The Dow Jones Industrial Average fell by 508 points or 22.6%. This is the largest fall recorded in a single day. While the crash originated in the US, the ripple effects were felt all over the world. The total losses originating from this event were estimated at $1.7 trillion. This event also led to the creation of circuit breakers and other such mechanisms by the regulatory authorities to prevent any future events of such magnitude.
Let us take a deeper look at the Black Monday stock market crash and attempt to understand why and how it happened.
First, we need to understand how such crashes originate.
Imagine a balloon. If you blow air into it, it will increase in dimension. If you blow more air, it will get bigger and bigger. This process will continue until the balloon reaches its capacity for expansion. After this point, if you try to blow even more air into the inflated balloon, it will not be able to take the strain and it will burst.
The stock market functions on a similar principle.
When the economy is doing well and there is surplus money in the hands of people, they tend to invest. Some of these investments take the form of bond purchase or recurring deposits. Some others manifest with the purchase of company stock. Here, we are only concerned with that fraction of investment which relates directly to the stock market.
When a lot of people invest in stocks, the demand for that company’s stock rises. According to the law of demand, as the quantity demanded increases, so too does the price of the commodity. In this case, the price of that company’s stock rises.
After this process occurs for a while, the general price level of stocks increase. This means the market values the company stock at a higher price than the intrinsic value of the company. In other words, the company in question is overvalued.
This eventually gives rise to a bubble. Much like the balloon in our example, this bubble in stock prices keeps on increasing. It gets bigger and bigger until the economy cannot bear its weight any longer. When it crosses its pinnacle, the bubble bursts in a spectacular show which sends stock prices plummeting.
You see, once investors become aware that there is a bubble in the stock market and that the stocks being sold are overvalued, they will start to sell. As more and more investors start selling their stock, the supply of stocks far exceeds the demand. Stock prices fall as a result. When this phenomenon continues for a prolonged period, it leads to a crash in the stock market.
The story leading up to the stock market crash of 1987 takes a similar form.
In the years preceding Black Monday, the US stock market was performing really well. People were investing and the stock prices were increasing steadily. In fact, between January and September of 1987, the US stock market grew by 30%.
The problem originates in the fact that although it takes practically no time for stock prices to increase, the growth potential of companies takes a gestation period. Once the investment is done, it takes a few years for the production process to complete and the benefits to manifest. A lot of investors actually understood this complex process. They realised that the increasing stock prices were not indicative of improvements in the company’s intrinsic value. Rather, they were the cause of incessant inflation and the creation of a bubble.
Once you know that a bubble is forming, the obvious reaction is to be hesitant about any further investments. Not only that, but prudent investors will also start thinking about how to protect their existing investments and their portfolios from the inevitable crash once the bubble bursts.
Institutional investors like mutual funds, insurance companies and investment bankers all started looking for options to protect their investments. They resorted to methods of portfolio insurance in order to protect themselves.
Portfolio insurance refers to methods of hedging and risk management. It differs from the traditional insurance policies that we purchase for health and life purposes in the sense that these methods do not offer any compensation on the occurrence of a particular event. These methods are not sold as policies by insurance companies. Portfolio insurance methods involve diluting the risk to one’s portfolio and protecting the investments from sudden drops or downward movements in the prices of stocks.
You see, diversification generally takes care of the risk associated with any particular asset or class of assets. However, the possibility of market risk still remains. In order to protect from market risk, investors resort to the short-selling of index futures. This can also be achieved through the use of put options.
What does this mean?
Fluctuations in the stock market are as common as the common cold. In fact, this phenomenon is so inherent to the very nature of the stock market that investors have actually come up with methods or strategies to protect themselves against sudden fall in the prices of stocks. This takes the form of derivative instruments like options.
Through the combination of put options with the underlying stock, investors can actually insure themselves against downward risk. When the stock prices are increasing, it is very obviously beneficial for anyone who owns the stock. On the other hand, if the stock prices fall below a certain strike value, the investor can exercise the put option and ensure a beneficial scenario there too.
This can also be achieved through shorting index futures. It refers to an agreement to sell index futures at a predetermined price on a predetermined date. Such contracts are transacted when one expects the price of the index to fall in future. Because the contract ensures a predetermined price, after maturity when the price falls, the investor makes a profit. Of course, if the reverse happens and the index actually increases in price, the investor would make a significant loss.
This seems like a strategy that any prudent investor would apply.
Then, why are we discussing it here?
Well, the reason is that when investors became aware of the bubble in stock prices, they all started shorting index futures. Because a large number of investors employed the same strategy, this imposed immense selling pressure on the US stock market. This signified to the rest of the economy that investors were losing confidence and it ultimately led to the Black Monday crash.
In fact, because the shorting of index futures was such a contributor to the stock market crisis of 1987, in the wake of the coronavirus led recession, a lot of countries have actually banned short selling to control the selling pressure on the stock markets.
One major reason why investors lost confidence in the US stock market and started selling is the trade deficit.
A trade deficit occurs when the value of imports exceeds the value of exports. This signifies that the economy is paying more than it is earning. It imposes a tremendous strain on the foreign exchange reserves, market prices and investor sentiments.
In 1985, the US recorded a trade deficit of $93 billion. In 1986, this figure rose to $136 billion. This rising figure signalled to the investors that the US economy was heavily dependent on other economies for the supply of essential commodities and raw materials. Prolonged trade deficits also impose a strain on the exchange rate of the country’s currency. All these factors resorted to reducing the confidence of investors in the US economy and they started selling their stock.
Another reason why the stock market crashed is the misuse of the concept of a margin call.
A margin call is a method of investing in which you can borrow money from your broker and buy shares of companies. When you sell the shares, the broker will take back their amount and the remaining is credited to you.
In the US stock markets, a large number of investors made use of the margin call to make lump sum investments in shares. However, once the stock market started declining, many of these contracts reached their margin call level. The brokers jumped and sold off the shares to make sure they were able to recover their margins. In fact, it was later revealed that several of these sales were conducted without the permission of the original investors. The large dumping of shares ultimately led to the stock market crash.
Of course, there are several other reasons why Black Monday occurred. These are simply the most important and the most noteworthy ones.
Be prepared, dear friends, for we may soon head in the same direction. The epidemic caused by the spread of the COVID-19 virus is imposing tremendous strains on the global economy.
The next question therefore is, how should you deal with such a crisis?
Well, in order to understand that, we must take a leaf out of the book of Warren Buffett’s investment guidelines.
Immediately after the stock market crisis of 1987, Warren Buffett invested heavily. During this time, he purchased a 6% stake in the company Cocacola.
This is because value investors are always searching for quality stocks at a discounted price. When the stock market crashes, all companies are affected. There is a general fall in the price level of stocks. However, this signifies the perfect time to invest as you will be able to buy truly undervalued stocks.
Well, dear friends, let us take the example of the Oracle of Omaha.
Take this opportunity to invest in quality stocks that are being offered at lower prices. Invest heavily during this time, and you will be able to reap the benefits later on after the market recovers.