The stock market has faced three major crises in the last 30 years. Many view such events, which have wreaked havoc on financial markets and the global economy, as unmitigated disasters. However, they should really be considered everyday challenges that the market must simply learn to overcome. We all encounter difficulties during the course of our lives, and we must push forward through these challenges in order to develop as individuals. In a similar fashion, the stock market must accept and adapt to the obstacles that it faces along the way, regarding them as opportunities for growth, rather than something to be feared.
On August 24 2015, financial markets descended into chaos, causing a massive sell-off across the globe. These events were led by a monumental meltdown in the Chinese equities market, fuelled by low oil prices and investors’ fears over another currency war following the further devaluation of the Chinese yuan. In the end, the crash was limited to a six percent decline across major markets, including the Dow Jones Industrial Average (DJIA), but it still serves as a reminder of the impact that China’s economic slowdown is having on the stability of the global financial system as a whole.
Panic selling in China was another factor behind the flash-crash of August 24. While the country has been a major contributor to global economic growth and low inflation for more than two decades, an unmatched collapse in Chinese shares sent shockwaves through financial markets, triggering one of the roughest trading days that had been seen in years, with billions wiped off of indices across the world.
But with every crisis, new and exciting opportunities may rise from the ashes, providing investors with the chance to buy big in the aftermath of a massive market sell-off. In an attempt to drive this point home, let’s look at three major market crashes that occurred in the past 30 years, all of which shared a common catalyst: a sudden inflation in asset prices, which would be met by governments slashing interest rates in an attempt to prevent an economic crisis.
The stock market must accept and adapt to the obstacles that it faces, regarding them as opportunities for growth, rather than something to be feared
1986 and 1987 were remembered as banner years for the stock market: a bull run, which got its pace in 1986, managed to fuel massive levels of liquidity in the financial system. Lower interest rates remained a primary cause for the immense money supply, which in turn resulted in hostile takeovers, mergers and leverage buyouts, and the floating of junk bonds (a method of gaining higher rates of return on investments for an average investor), among other tools designed to attract the hard savings of the common man.
Market excitement was so intense that ‘booming’ came to describe a never-ending phenomenon. These positive developments were not a free lunch, however, as illegal inside trading, rapid credit and economic growth put pressure on inflation once the Federal Reserve System eventually began to gradually increase the lending rate. This monetary tool acted as a trigger point for massive selling and proved to be a nightmare for investors. Hedging of portfolios against rising rates therefore defined the crash in October 1987.
Soon enough, critical panic turned to a joy ride when the Fed intervened, instantly lowering the interest rate in order to prevent further free-fall. The market turned into a bull run soon after, something that was further bolstered by companies that possessed attractive valuations and strong fundamentals. Those who showed their courage and put their money where their mouth is were rewarded in the later stages of the run, as the market saw a handsome return of around 60 percent in less than two years after the lowest point of crisis.
The dot-com bubble
A similar situation played out in 2002 during the dot-com bubble (see Fig. 1). The foundations of this crisis were laid way back in the 1990s, when enthusiasm surrounding software companies led to the creation of many small start-ups. Most of these companies were fledgling and had been launched by recent college graduates, and so high profit margins attracted many venture capitalists whose only aim was to reap enormous profits after the companies got floated on the stock market. This led to many start-ups paying their employees with company shares.
At this stage, the internet age was born and took IT services to a new level. Economists started believing in a new economic balance, forgetting the age-old economic conscience of resources and retailing – as a matter of fact, the NASDAQ boomed from a level of 500 in May 1995 to 4,700 by March 2000 (up 940 percent in just five years). At the peak of this tech bubble, it was said that a new millionaire was created every 60 seconds in Silicon Valley.
But by early 2000, investors had realised that such high valuations were not sustainable and that a massive speculative bubble had been fuelled. When the penny finally dropped, the NASDAQ went into free-fall; toppling from 4,700 points all the way down to 804 – a drop of 83 percent.
The Fed once again intervened, introducing a lower interest rate that provided a cushion and allowed the market to slowly regain its pace. In fact, it had recovered by almost 93 percent in a short span of 15 months.
Subprime mortgage crisis
The script for the 2008 financial crash was written back in July 2007, when daily financial markets were all but ruined by a credit crisis. This sowed the seeds for mortgage companies to begin selling subprime mortgages, which wreaked havoc on the global markets.
The combination of rising interest rates and borrowers’ inability to repay their debts saw panic buttons being pressed across the investment and financial industry: in October 2008, 21 years to the month after the 1987 crisis, investors were shaken by another mammoth economic meltdown. The federal takeover of Fannie Mae and Freddie Mae, the collapse of 158-year-old investment bank Lehman Brothers, the takeover of Merrill Lynch by Bank of America, the liquidity crisis at AIG, and the seizing of Washington Mutual Fund by Federal Deposit Insurance Corporation were all key repercussions of a mammoth event that jolted stock markets across the world.
But what is significant above all else is the quick action that was taken by various governments in order to prevent the crisis from turning into a full-blown collapse: interest rates were cut, while fiscal stimulus packages of varying magnitudes and quantitative easing remained key pushers for the markets.
Following the G20 summit in London, which brought global leaders together to curb the crisis and instil confidence in the financial markets again, $5trn worth of fiscal expansion was poured into the economy, helping to boost employment and growth in the process.
Recovering from a crisis
The market, after some more volatile hiccups, eventually started to see signs of life again. From a low of 6,500 in March 2009, the DJIA jumped and crossed the 10,000 threshold after only one year, returning more than 60 percent of the value that was lost.
Across all of these turbulences, there are two common factors: first of all, panic played a huge part in the downward spirals of the markets. However, it is clear that the scale of panic nowadays is much larger than it used to be, with investors constantly feeling stretched beyond their capacity. With the knowledge that stock prices around the world are generally inflated on the strength of tall tales and cheap money, investors now live in constant fear of everything crashing down around them.
The second factor is the recovery of the markets in question: historically, every single market crash has eventually proven to be nothing but a buying opportunity, which can easily be used to serve the purpose of boosting one’s returns.
For professional shareholders, irrespective of any market trends, an urge to search for ‘poor man’s stocks’ should be constant. For amateur investors, the solution is surprisingly simple: choosing a handful of equity funds with good long-term track records, steadily investing through Systematic Investment Plans (SIPs) and, most importantly, continuing with these methods even during a crash will provide the solution.
The basic idea behind SIPs is that, while the general direction of an equity investment is upwards or downwards, it is not possible to reliably predict the actual fluctuations that may occur. As such, the whole point of investing steadily in a mutual fund – and continuing to do so even during difficult times – is so that investors do not have to attempt to force the market.
Moreover, it is important to understand that in the medium to long term, the only thing that truly matters is the state of the local economy: in a growing market, a crash is always a buying opportunity. A steady, systematic investment strategy was the right one a decade ago, a year ago, a month ago, a week ago and today, and will undoubtedly remain so for the foreseeable future.