Learning from the history of depression and stock market crashes

Every few years or decades, we witness a state of the market that is somewhat shaken. A stock market crash and depression is as important as a bull market and provides lessons for further development and growth

Publish Date: February 20, 2018

By: Sandhya Kannan, Head – Content

Stock market crash and depression have been a part of the markets since time unknown. It can, however, be understood and dealt with in this way: think of it as part of a cycle. If there is high liquidity, demand, large numbers of jobs & production, then there is bound to be a fall in the same as well. ‘Depression’ is a term used to describe a prolonged period of fall in economic activity in one or more economies. It is severe than a recession since it extends beyond a normal business cycle.

When a market or stock index crosses the fall limit of 20% in one trading day, the phenomenon is known as a stock market crash. It can be caused by fearful sellers & unexpected economic events or catastrophe and crisis that can trigger panic in the market. The pattern that emerges before a stock market crash is that of an extended period of the bull market. This is where the greed steps in to drive the stock prices to unrealistic and unsustainable levels. In this situation, the stock prices often surpass the true value of the company and the price to earnings ratio is higher than the average.

While every depression results in major havoc tumbling an economy, there are lessons to be learned from each one of them. From the factors affecting the depression to the way in which the markets pick themselves up, every depression is unique and the learnings from them can be kept handy for future imbalances.

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Let’s look at some specific bursts that brought economies into the depression zone!

The first depression recorded was due to Tulips. Yes, the flower!

So, the first depression was recorded in the year 1634 when the Dutch Tulips created a stock market crash. The flower was first imported from the Ottoman Empire, now Turkey, to Europe as an exotic status symbol. This created a huge demand among the elite as a result of which the prices spiked within a span of 3 years. The spectators soon hit bankruptcy when they miscalculated that the demand would keep rising forever when everyone started buying these flowers. This depression was so severe that it took the Dutch economy several years to recover.

Learning

The overnight sweep out of tulip bulb prices taught suppliers the supply-demand chain. The skyrocketing prices coupled with its growing demand was a sign enough that the demand from the elite would soon plummet which will create a ripple effect among other consumers.

From this usual unusual event, the investors understood that the markets can turn very irrational very quickly and it is important for them to catch such incidences. More than that, it is important that the investors do not get carried away by investing in a hurry. It is important to take a step back and look at the trend, analyze it and time your move accordingly.

Dot.com Bubble Burst of 1999-2000

While some crashes happen within minutes of a trading day, others take some time accumulating the losses over a period of time. The latter is what happened in the case of the Dot.com bubble burst. The technology was pacing fast and furiously, expanding in every direction. The investor's interest raised tremendously in internet stocks in the 1990s. “New Economy” stocks like AOL, Pets.com, Webvan.com, GeoCities, and Globe.com were the major stakeholders of this movement.

This movement was confirmed when the IPOs of Globe.com opened at a sharp $87 per share as compared to its original asking price of $9 per share. It raised $28 million and had a market cap of $842 million. However, 2 years later, many Dot.com companies fell because of highly inflated stocks, including Globe.com. The fall was so adverse that it dropped below $1 per share because of which Nasdaq delisted the share and fell from 50,000 in 2001 to just 1,000 in 2002.

The recovery began when Wall Street started evaluating the financial stability of high-tech companies more closely and accurately.

• Learning

  Post this burst, investors became more cautious about the companies they were going to invest in, especially ones that belonged to the high-tech sector. It became more important to research well and have all the facts in place through proper analysis and research of the company and its stock prices.

  Since the investors became aware of the new ongoings in the market, Wall Street tightened its criteria for evaluating financial stability. NYSE wanted to be sure that such a burst is not caused another time due to weak analysis techniques and changed intuitively as per the investor’s intelligence.

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The Great Recession of 2008

The Great Recession came into the picture in 2008 where the Lehman Brothers were tagged as the key trigger of the meltdown. They used high-risk derivatives as collateral to fund their short-term financial goals and raised the stakes immensely.

Even though the Great Recession did not affect the Indian markets much, the global climate played a role enough in pulling down the Indian stock indices. The Bombay Stock Exchange witnessed a fall of 1408 points on 21 January 2008, which led to one of the largest falls in investors’ wealth. Since then, that day has been referred to as Black Monday.

The fall was allegedly due to the predictions made by the analysts at HSBC mutual fund and JP Morgan. They were of the opinion that the markers will fall further considering the global conditions and the then persistent volatility of commodities. After witnessing a series of plunges through the year, markets started showing a ray of hopeful recovery in 2009.

• Learning

  This bubble burst happened due to the easy lending standards set by banks. The easy credit brought into the whirlpool everyone from car owners to students and the major sector that borrowed money, businessmen. To recuperate from this burst, the banks tightened their loaning standards and fixed it for only those with a strong credit score.

  Since a major lesson learned from this recession was that the stock prices can keep falling for a long time, a smart investor is expected to buy on the dips. This means that an investor must buy the stocks with falling prices since they won’t remain that way for a long time.

Time for Lessons

There are 3 reasons that build up a stock market towards depression:

1. A market that is over-valued

2. A type of financial engineering that comes across as a contraption

3. A factor that might not be directly related to the market

Even amidst a stock market crash, there are ways in which investors can safeguard themselves. The first and foremost is to develop a stock investment plan which will determine the goals an investor hopes to achieve, the kind of stock that must be invested in and a thorough analysis supporting it.

A major element of the plan is to include money management and risk management plans. That way, you as the investor, will be able to minimize losses tremendously. Not all investments you make will be successful which is where diversification comes in as a very handy technique. To add to that, you should always be prepared to curb those losses with the right rules in place.

The aim is not to get out scot-free, as that is a hypothetical situation, but to cushion the blow of a stock market crash! It is important to have enough knowledge to judge the markets and trim your stock holdings if and when you are close to a market depression.

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