Why do markets fall? The causes of stock market corrections, bear markets and other meltdowns.
When the stock market careens around wildly like a drunken bull, it causes even the most steadfast among us to become nervous. It causes some of us to jump into action. Whether these moves are unplanned or not, it’s a testament to how human behavior is greatly influenced by emotion. When the markets take a dive, it plants some thoughts in our heads such as:
- Will I lose my shirt? When will the pain end?
- How much should I buy? I want in!
- Let’s change the subject, I don’t want to begin to know what’s going on with my money right now…
So what camp do you belong to? For most of you who are younger and are capable of withstanding risk, you’d say category #2 — you’re in the buying camp. But remember that making such a proclamation would all depend on your age and risk profile.
When Is It a Bear, a Correction or a Bull Market?
One way to monitor the market’s health is to check the net outflow on mutual funds. During the worst events that have happened in the United States (e.g. the situation with 9/11), net redemption from funds stood at $16 billion. So you can get some idea on what could happen when the unthinkable happens at a large scale. As far as terminology goes, let’s remind ourselves for a moment about how the stock market is typically described:
We’re in a bear market if we’re down 20% from the peak.
We have a correction if we’re down between 10% to 20% from the peak.
We’re riding a bull if it’s up greater than 20% over the span of a year.
Technically speaking, if you’ve touched 10% down from the peak, then there’s some potential here for some pain in future days. From what I’ve seen in the past, as someone who’s lived through several corrections and two bear markets, the market gyrations take a while to wind down. So in a situation like this, a revisiting of the bottom is likely to occur, especially if bad news continues to permeate our economic and financial atmosphere, and the media insists on dwelling on the negative.
Let’s take a look at what could cause market jitters and review what factors could cause the investment market to go to the dogs:
Fundamental Reasons for Stock Market Gyrations
Supply and demand affect the behavior of the stock market, but when does demand dry up so much to cause a negative change in market trends? Throughout history, there have been many causes for the precipitous slides we’ve seen. For instance, here are some basic economic reasons: the sputtering housing market, the subprime lending and mortgage mess, tight credit, weak dollar, inflation or threat of inflation (or deflation), perception of an overvalued market, the market touching new highs, and so forth. And sometimes, it seems like the market goes down for no reason at all (blame it on dark matter in the investment universe or some other unconventional reasons that spook traders or investors).
During many a correction or bear, it is not unusual for us to see the actions of institutional investors and big money managers (the so-called market makers) trigger or exacerbate a sell off. After all, they delve in high-risk and complex investments and are in the trading game, where snap decisions and quick moves are required. During periods of volatility, traders bail out while regular investors like you and me stay put. I’m of the mind that it’s the sanity of the small investor that doesn’t make things worse than it already is.
But let’s take a peek at a 15 year period in history to learn some of the causes of the worst downturns of this period. Understanding these causes may help us put things in perspective. These were crashes that I lived through and witnessed, as a long term investor.
The 1997 Asian Economic Crisis. The developing or emerging markets in Asia crashed and continued to suffer for a couple of years. Effects were felt in Hong Kong, Philippines, South Korea, Indonesia, Thailand, etc. “Financial contagion” made things worse. The main reasons for this crash? Real estate market drops that compelled the Thai government to float its currency due to debts. More details here.
The 2000 Dot Com Bust. Alright, who saw this coming? The dot com bubble marked the 90s decade and I remember being in the thick of it, here in Silicon Valley. This was quite a memorable period, with everyone thinking they would soon be millionaires. High-flying internet companies were grossly overvalued with people going crazy over IPOs. This is a classic case of the “madness of crowds” (ala the tulip mania).
The 2001 September 11 Debacle. Terrorist attacks are exogenous events that may come unexpectedly. These are less predictable, but when they happen, they can send an inflated market into a tizzy. Political fear and public security or safety concerns can spill into the financial markets and bring about economic dread.
The 2008 Financial Crisis. This was one of the most fearsome market drops in recent history. We worried over the plight of big banks, bad unemployment numbers, a “great recession”, talk of a looming depression, foreclosures and the struggles of so many homeowners who simply borrowed too much for their homes. What begun as some credit troubles affecting the housing sector escalated into some sort of “financial contagion”. Before this crisis hit, exotic financial products were being spun off of mortgages — a sure sign of a building mania.
The 2010 European Debt Crisis. More debt problems in Europe threaten to sink world markets. Blame Greece for yelling “the sky is falling.”
The 2011 Mini Crash. It’s not so bad in the whole scheme of things, but as expected, people wailed and gnashed their teeth. Reason for this fall? The U.S. credit downgrade from AAA to just AA+, and the specter of debt (consumer and federal) continuing to loom over the American economy.
As you can see, in recent times (and I suspect even in past history), DEBT is one notorious monkey on our collective back. The terrible mojo in the markets can most often be traced to debt problems and bubbles. Who knows when or even if the world will recover from its massive debt issues and imbalances? Should you bury your head in the sand or make like Chicken Little? I think the response we should have is something in the middle: watch warily and have a plan before you act. The takeaway here is that we should expect market cycles to periodically bring volatility. Realize that we’re always vulnerable to cyclical shake-ups and that we should always be ready for the market to turn around unexpectedly. And remember that there’s opportunity in negative situations, so learn how to leverage a weak market.
Created August 20, 2007. Updated August 28, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.
{ 19 comments… read them below or add one }
I’m number 3 . . . not because I’m afraid, but because I’m lazy.
A big problem we’re facing is that we’re getting used to the Fed bailing us out each time the markets behave badly. This teaches us to be complacent investors, borrowers, consumers. It’s like the “boy who cried wolf”… and it will be business as usual once the Fed does its thing and the market is on track again.
I’m definitely #3. Better off not knowing. If you have a good investment strategy, and you’re in it for the long run, there’s no real need to start looking into your account every minute. I actually fell to the urge once last week and immediately wished I hadn’t, since I had a sudden panic urge to sell.
I do think it turned into a panic, though. After 9/11 there were serious market instabilities – it took a week for the NYSE to reopen, there were the anthrax attacks and so on. Now it’s a small slice of the housing lender market failing. No small thing but not a sign of a long-term structural instability. The Fed overreacted massively, I think, and we’ll soon see a new round of irrational exuberance as all of that funny money props up the system again – which is great for those of us who stay in the market, right? Right?
@Telemill,
Sounds like you may have been hanging around Lazy Man’s blog too much. If not, you should. He’ll show you what true laziness means (his money does all the work, apparently).
@John,
Cycles come and go, and the Central Bank, Fed, and so on do their thing to keep things humming along. The bull market’s strength can attest to the banks’ success at getting things under control (in these cases). I don’t quite subscribe to as cynical a view as you do with regards to intervention.
@Brip Blap,
I remember those anthrax scares. If it’s not that, it’s something else scaring us. I remember the avian flu thing a few years ago too. Oh my, now you got me all paranoid. I’m much more nervous about plagues than I am of stock market crashes. Must be because I haven’t seen a plague up close yet, whereas market crashes/dips/shakeouts are a dime a dozen.
If the stock market makes you nervous is is critical to asses your asset allocation. If you can’t withstand a market correction, then you should have a more conservative allocation. One of the biggest mistakes is buying high and selling low.
SVB, thanks for the plug. I’m actually finding myself in #2. Unfortunately, it looks like things are already getting better before I can get some significant money in.
From what I’ve read the big money boys are liquidating so that they can cover their debts which were created by exotic financial transactions. And the bailing out by the Fed and European Central Bank is definitely not a plus in my view. I’m heading for the gold!
SVB, it’s the fear and irrational lack of it that drive the American markets. One about of about three different bad scenarios will happen someday in the near future and send the markets on a kooky free fall that will make this correction look like a teeny blip:
1. Another terrorist attack in the US
2. An outbreak of disease X somewhere in the US or Western Europe
3. A significant corporate collapse (imagine Enron happening to GE – it could, there are no sacred cows…)
Cheery stuff!
Hi,
If you could give me some advice i would really appreciate it:
I have invested £90,800 with HSBC. My financial advisor there talked me through it all and, based on his understanding of my level of risk taking, we placed it into a Taxed Plan. This was split 10% here, 10% there etc. Some in low risk, majority in medium risk and 5% in high risk. This was in December 2008. In January 2009 i had £94,000. Now, March 2009, I have £84,000. I have had £10,000 wiped off its value in 8 weeks. This has really made my knees wobble! I am now considering cutting my losses, cashing in and putting my money into a property which i will live in. I am new to investment, i do not understand it completly. I would really appreciate some advice – i do not know what to do. Should i cut my losses and grab my £84k now, or do i leave it in. I do understand that i am only 4 months in to a 5 year plan but i dont understand what the point to leaving money in an investment that is going down – and i expect it to go down more. Should i take what i have now or shut my eyes and look again in 5 years???
Kev,
First off, I am not a financial professional and neither is anyone who joins our discussion here (as far as I know) — we’re just regular people all in the same boat as you. But here’s what I can say: the conventional wisdom of long term investing is to stay put. Is your money for the long term (say for 10 years or longer?). If so, then you should “stick to your plan”.
But it seems that you also have a property you own. And you are right — that is an investment. Here’s the thing — if you can accept your losses and cannot take the volatility, then sure, put your money towards your property. But realize that there is a huge risk of missing a recovery and potentially making up your money at some point.
If you realize you aren’t able to handle the volatility, then you should put your money in something “safer”. There is a huge risk here that as soon as you switch investments, your original investments will go up while your new investment doesn’t (or worse, goes down). It commonly happens…. why? Because the “bad” investment usually recovers eventually, while the “good” investment you see now may have it’s day to tank.
It’s a big decision to do this, and nobody knows what tomorrow will bring. But do the switch if you are prepared for anything — even losing out on the possibility of a powerful recovery. It’s happened many times in the past — but you can’t say for sure what’ll happen this time (though the chances are that it will happen again). We can only talk probabilities here.
I am fairly comfortable with my asset allocation so I am staying with my strategy. I will review it in December as I always do.
Fear and greed, greed and fear, come and go in cycles like the tides. Those impulses are always looking for some scrap of news to latch onto. But all that really counts are discounted future earnings and cash flow in relation to price. As Buffett says, in the short run the stock market is a voting machine; but in the long run it is a weighing machine.
No company really becomes almost worthless overnight, unless theirs a real scandal. There are artificial dips when fear takes over, and there are corrections when companies were never really worth anything in the first place.
The recent fluctuations are caused by fear, hopelessness and people gambling instead of investing. The stock market will continue to gain in the aggregate over longer time frames (5 or 10 years).
My gut response when I see a dip is “Blue light special!” My rational brain then reminds me, I don’t gamble, I will invest the same in an up market and down market and will not try to time the market. Basically saying I think #2 first when I know I should thinking #3 always.
Just imagine how much more volatile the stock market would be if it wasn’t for all those 401K’s and pension plans which are subject to frequent trading restrictions.
But is volatility really a terrible thing? It actually depends on perspective. If you’re a long term investor, it’s not something you wish for but it’s something to tolerate and accept as part of investing. But if you’re a day trader or short-term trader, this is the type of market environment you live for and hope to see more often.
I would say the primary cause for market crashes is the failure of the majority of folks to do their due diligence in determining how much to pay for a particular investment product.
If stocks are going up, everyone wants to jump on board regardless of how far the market has already moved. The quickly devolves into the “greater fool” approach as people buy blindly and hope someone will be foolish enough to buy it from them at a higher price. Eventually the market runs out of these greater fools and the markets proceed to crash.
Typically, all the clear warning signs are clearly in place for anyone who’s observant – valuations become disconnected from all rational historical measurements. Unfortunately, people are typically blinded by $$$ signs to see the obvious warnings until it’s too late.
By the way, I’ve been meaning to ask: was your blog always intended to be on personal finance? You’ve probably discussed this elsewhere so excuse me if this is a rehash, but your blog title brings to mind technical applications, like reviewing the latest gadgets. =)
@Soullfire,
Thanks for the great comment! I echo your thoughts on the greater fool theory. But forgive me for going off tangent on this topic in order to answer your last question — yes, my site is about personal finance. I actually tried to explain the name of my site before in my About page. 🙂 Basically, this site is about sharing personal finance resources, tips and ideas online. I am also from the world of technology and am also interested in seeing how finance and technology can work together to help people make smarter financial choices. That is the premise.
I also aim to make this vision clearer over time. I have a lot of stuff in the pipeline that will hopefully shed more light on my site’s name and mission. Thanks so much for asking! I love questions like this too.
@SVB,
Ah, I see. Looks like we both have our roots originating in IT/Engineering and are pursuing new ventures. =) I’m trying my hand at short term/day trading and I have to say my tech background has proven to be very useful in setting up my approach and methods, as well as being able to put in those monster hours in solving problems and dealing with the learning curve. 😉
The majority of folks I know invest with a hope and a prayer as they have little financial knowledge or financial strategy so blogs like yours will certainly help cast light where it’s needed.
@Soullfire,
Thanks for the kind words! I find that people with a technical background are certainly more comfortable with the trading world. In fact, I’ve heard that several tech-minded folks who have a passion for trading have themselves created their own trading platforms and turned their work into a full time business. But yes, there is a tight correlation between tech and finance — and that’s why I love covering this area. You can be a trading whiz by having a fast-thinking math/tech oriented brain with a great understanding of psychology.