Stock market crushes: loss of money or new opportunities for trade?

Nowadays we are regarding one of the deepest stock market crashes in the history. Fear and panic spiral out of control and drive stock prices to unthinkable lows. Many traders have lost everything while many more have totally given up on stock trading. 
Some time later the entrepreneurs will start wearing t-shirts proclaiming “I survived the stock market panic of 2008”. But economic crises are nothing new. If you learn the lessons of the past, you can overcome difficulties and gain from the new terms of stock trade. 

Historical examples

In the last several centuries, the world has seen numerous economic crises, recessions, high debt ratios, price bubbles and stock market crashes. They date back to the 17th century, when investors in Holland boosted the price of tulip bulbs to fantastic levels. 

During the first half of the 18th century, there were several financial bubbles related to joint-stock companies. In 1819 the Second Bank of the United States, seeking to stop speculation in commodities and western lands following the War of 1812, contracted its extension of credit. This decision triggered the panic. 

The crush of 1873 was a combination of railroad speculation, a run on physical gold, and large banks and brokerage houses failing. This event nitiated the Long Depression in the United States and much of Europe.

The uneasy state of British securities markets in 1890 stopped the flow of foreign capital into American enterprises, and the sale of European-held securities caused a stock market downturn in New York in 1893. 

Sometimes called the "rich man's panic," the collapse of 1907 resulted from speculative excesses in life insurance, mining stocks, railroad and coastal shipping, and inadequately regulated trust companies. Even though the panic didn't trigger heavy unemployment or massive bankruptcies, it hurt the image of the big financiers.

The most devastating economic collapse of the 20th century was the Wall Street Crash, also known as the Great Crash or the Stock Market Crash of 1929. This event is widely regarded as the beginning of the Great Depression, one of the most difficult periods in the U.S. history.

The next major global downturn came in October, 1987. It is referred as Black Monday because stock markets around the world crashed, shedding a huge value in a very short time. The Dow Jones Industrial Average tumbled 22.7%. 

The Japanese stock market crushed in 1990, with the Nikkei shedding 75% of its value in just several months. Share and real estate price bubble burst and turned into a long economic downturn. The time after the collapse is known as the "lost decade or end of the century" in Japan.

The "dot-com bubble" was a speculative technology bubble covering roughly four years (with a climax on March 10, 2000) during which traders saw record-setting rises in stock valuations of dot-com companies.

The Chinese Correction was the global stock market downturn of 2007. The SSE Composite Index of the Shanghai Stock Exchange fell 9% from unexpected sell-offs. It was the largest drop in 10 years which provoked global stock market crushes.

Understanding the reasons

All stock market panics are a bit different, but they have many similar features, including overinvestment and falling prices. The process can be described as a way from greed to euphoria and finally to fear. 

First of all, a certain type of investment becomes tremendously popular. Those with a vested interest in the shares boost their price because they want to see the value of their assets rise. They are trying to suspend disbelief, even if evidence tells that the assets are overvalued, or if it is obvious that they won't receive expected dividends.

People who do not understand what they are buying stand in line to take advantage of the new opportunity to earn money . They behave in a herd mentality. If all people buy new shares, they also don't want to miss out this promising opportunity for investment. 

When a piece of negative information emerges. The media full of depressing news is a good "misleading" indicator. A kind of mass psychosis is taking hold of investors. That makes them overreact. 

Panic in financial markets - just as in everyday life - is explained by the fight-or-flight instinct. Investors start to sell off shares, all at the same time. They want to get out of the investment, with little regard for the price at which they sell. Wide-scale stock selling causes a significant decline in price.

The main problem with stock market panic is that investors are selling their shares in reaction to pure emotion and fear, rather than analyzing fundamentals. Most large stock markets use trading halts and curbs to limit panic selling and restore some degree of normalcy. It allows people to stop and evaluate information on why the panic is occurring. 

There is another point of view on the reasons of stock market crushes. Some experts believe that any collapse is just a historical event in the continuing process known as economic cycles. Stock market crush is a way to return to normalcy – a “correction”. Its aim is to increase the speed at which the economic cycle proceeds to the next level.  

Why can't investors learn from history? 

Speculative frenzies are often accompanied by a theory of a fundamental economic shift combined with some type of financial innovation. Each trader pronounces that misleading phrase, "It's different this time". 

In Holland in the 17th century newly imported tulips were so beautiful that people believed that their bulbs could cost more than gold. The South Sea Bubble of the 1710s was driven by a faith in the new lucrative opportunities of Trans-Atlantic trade.

U.S. investors in the 1920s were enchanted by new promising industries such as car-manufacturing and broadcasting. In the beginning of 1990s, they got interested in Japan. The dotcom bubble was supported by the faith in new online technologies. 

In addition, stock market crushes are considered to be extreme events because they – luckily - don’t happen very often. So when a collapse happens, it comes as a big surprise. One of the main mistakes is to extrapolate it out into infinity. Collapses are not endless – some time later each of them ends and we forget about its reasons, enjoying a new quiet period of time.
 
What about the latest stock market crush? 

The latest financial crisis is a bit different from previous turndowns. It didn't result from a bubble in share prices, but rather from a banking crisis combined with the following recession. Stock exchanges are slumping according to these two factors. 

However, the banking side of the financial crisis has common features with panics in the past. Trying to increase their profits, lenders have granted mortgages to thousands of Americans who simply weren't able to pay them off. 

Then corporations invested money in complex financial securitisation packages such as "collateralized debt obligations" consisted of these subprime loans, without understanding exactly what they were buying. 

So not only stock traders are scared, but also financial institutions. Dysfunction in the credit markets indicates that the players don't have the confidence to transact business with each other. The panic is in the industry itself. 

Are stock market crashes more dangerous nowadays? 

Perhaps the main innovation for the last dozen of years is the influence of hedge funds and computer technologies. The wave of stock selling is often pushed by hedge funds and other financial institutions that need to sell their holdings in order to free up some cash. The crush of the American hedge fund Long Term Capital Management (LTCM) is a good example of such an influence. 

After default in Russia in August 1998, investors fled from Russian government papers to much safer US Treasury securities. LTCM, which had taken numerous loans from other financial institutions to buy international bonds was losing billions of dollars. It had to sell its Treasury bonds. It crushed US credit market and made interest rates go up. 

New computer technologies can also affect on stock market panics. The most popular explanation for the 1987 collapse was selling by newly launched computerized trading systems. Program trading was based on external inputs, such as the price of related securities.

In 2000 companies were seeing their stock prices skyrocket if they just added an "e-" prefix to their name and/or a ".com" to the end. It led to a dot-com speculative bubble in 2000.

When might this downward spiral end? 

A stock market panic can be very scary, but it doesn’t mean the end of the world. All people are very adaptable. Put us in a bad financial situation, no matter how unpleasant, and it doesn’t take us a lot of time to adapt to the new environment. 

Nowadays market conditions that scared traders and investors in the beginning of October seem to become a kind of routine. We are all becoming numb to extreme volatility, which really eliminates fear. And as soon as rationality returns, stock prices will recover. However, keep in mind that stocks always drop faster than they go up.

Time to buy

Some of the biggest fortunes were made when the stock market was slumping. Many investors realize that lots of valuable assets are trading at deep discounts. They bought cheap stocks and hold them until prices went back up.

For example, Jesse Livermore made $3,000,000 from just one trade in the panic of 1907. Floyd Bostwick Odlum managed to turn $39,000 into $100 million. John Maynard Keynes invested in some companies that were undervalued after the stock market crush and earned millions in the end. Andrew Carnegie and John D. Rockefeller had enough funds to buy out their competitors at a very low price. 

Baron Nathan Rothschild was a respected French investor who became a legend during the financial crisis. When a building boom ended with a mortgage bubble bursting, he told his clients – "It is time to buy." Rothschild proved to be rather prescient. The investments that he and his friends made doubled in value! 

The point is, there is an opportunity to make money in a recession. People panic faster than they get greedy. No one wants stocks, so fortunes are made by the brave few people who buy stocks when all other traders are selling. So if you can take the long view, suppress your own fear and ignore the herd’s behavior, you can take advantage of new lucrative opportunities presented by the stock panic.

Some experts say that this financial crisis is different. Neithers traders nor investors are making money because trades are dificult to initiate on both ways. People don't want to invest money in equities. However, the Internet shows that "buy foreclosure" is one of the most popular searches. Either we are going to go into a new Great Depression, or many people want to buy assets at very attractive prices.