FINANCIAL FOCUS
Market Crashes
In this installation of Financial Focus, we will discuss the topic of what actually causes “Crashes” in equities markets. As always, we will provide some education and commentary for the inexperienced and/or uninformed.
In Chapter 1 of our publication When to Buy and When to Sell: Combining Easy Indicators, Charts, and Financial Astrology (available on Amazon), we discuss the Economy and Market Emotion, both of which play a role in potential market downturns. Despite popular belief, neither institutions, market makers, military conflict, black swan events, negative economic reports, nor negative media coverage are generally a single factor that prompts a true market “crash.” The real culprit is a Credit Crunch, which can be triggered by some of these mentioned issues.
A Credit Crunch is basically defined as a “sudden, severe reduction in the availability of loans.” Financial institutions, mainly banks, restrict loans during these periods, which results in rising interest rates, which in turn causes loan defaults, property foreclosures, damaged credit, and/or the inability to borrow. That then snowballs into investor panic, less capital for investment, business failures, equity bubbles bursting, and massive economic downturn. Some well-known examples of a Credit Crunch are the following…
· The 2008 Financial Crisis, caused by the Housing Bubble credit freeze. A surge in high-risk loans, high-leverage mortgage schemes, little regulation, and adjustable rates caused a massive home price increase bubble to burst, resulting in the deepest recession in 80 years. The indexes lost 38-40% and took years to recover.
· The 1966 Credit Crunch was a result of high inflation, rising interest rates and the Viet Nam War. The monetary policy was tightened during this period in which the S&P 500 declined about 22% (a strong correction), though it only lasted about 8 months, and did not trigger an official recession.
· The 1929 - 1930 Great Depression was considered the worst case in history, triggered by reckless credit expansion and ineffective management by the Federal Reserve - leading to mounting consumer debt, decreasing consumer demand, bank failures, excessive unemployment, and poverty. At its height, the stock market dove a whopping 89% in 3 years, including 25% in a 4-day period in October of 1929. The end of the depression, ironically, was derived from massive government defense spending and manufacturing for World War 2.
The key factors regarding Credit Crunches/Market Crashes are related to their effects on banks and other lending institutions. When property or equities drop significantly, it negatively effects their higher-risk lending (2008) and balance sheets, and increases their regulatory oversight. In some cases, as they decrease lending, they are forced into selling assets under market value to raise cash, further driving down those prices. This can then result in less ability to re-finance, slower business activity, rising unemployment, foreclosures/bankruptcies, and occasionally bank failures, which then turns into the liquidation of assets (including stocks) and less investment. These factors then contribute to “crashes” in the equities markets, as opposed to “corrections” or “pullbacks,” and often take the longest to recover.
Currently, there is a general concern regarding private lenders, which have increased significantly over recent years, most of which have not experienced a credit “bust.” If these businesses are too highly leveraged, a quick, painful collapse may occur, and they are unlikely to receive a “bail-out” that large banks have experienced in the past. Historically high government debt, another housing and stock market bubble, as well as higher interest rates and unemployment, are all weighing on investors, many of whom are waiting for “the next shoe to drop.” Times are different concerning measures that can be taken to avoid this type of disaster, but greed never fully disappears.
It is important to be aware of the credit atmosphere, and to avoid getting caught in an over-leveraged situation, especially with real estate, which is much harder to liquidate than stocks. Diversification in your investment holdings beyond your home and speculative stocks is also wise, as certain industries will rise, or falter, in various economic situations. Bonds, metals, other physical assets, and even Inverse ETFs (that rise when markets fall) should be researched for potential investment.
For additional discussions and education, please continue to visit us here on ASTRO-FIN.com, where we provide periodic updates on a variety of topics.
***As always, this information is not intended to be financial advice, or any specific buy or sell recommendation, but rather a guide to assist the reader in some further understanding of current economic conditions.
