Market crashes explained

We all have heard about the market crash of 1929, The Great Depression. We also probably heard (or lived) Black Monday of 1987. More recently, the Dotcom Bubble in 2001, the financial crisis in 2008 or the Covid pandemic in 2021. Fear of losing money crawls in our backs as we think of them.

But what’re market crashes? A market crash is a sudden drop in financial asset prices, unexpected to most investors. Even though economic crisis and catastrophic events are usually cited as causes, it’s fear that takes the protagonist role. In this sense, crashes may be mostly irrational, as in based mostly in emotions than what true numbers would grant.

But other times crashes are the inevitable consequence of long-term bubble feeding. Investors realize they were buying a bubble because suddenly the market price (read: other investors) tell them. But why did we buy the overinflated asset in the first place? Well, it might take an iron will to abstain from doing so when all of your neighbors are making money on an asset that “can only go up”.

There’re usually three ways to correct a very overpriced asset. The first, the price gets stale until growth (economic reality) catches up, justifying the now not-so-high-anymore valuation in relative terms. Think for example of a high growing company which price goes nowhere until revenues and earnings have grown sufficiently to justify the current price.

A second way the correction may take place, is when during a long period the asset price suffers a gentle slope down, correcting itself to a more reasonable valuation through time.

Finally, the third is the crash. Prices drop suddenly, as investors learn the hard way “it was all a lie”.

So how do we distinguish a “rational” crash (illusion bubble bursting) from an “irrational” one (not numbers-justified but out of sheer panic)? Was the market wrong before the crash, or is it wrong after? Or is it somewhere in between?

There’re several causes that may ignite market crashes. A spark, like a higher-than-expected inflation, a rise in interest rates, earning misses, war, a pandemic, an earthquake or flooding, etc., could turn into a full-fledged fire when combined with the following fueling factors:

• Fear: Ever heard of behavioral finance? It’s a mix of Finance and Psychology, which tell us many interesting things. Among those is that our brains are wired to feel suffering (psychological pain, if you will) when we watch our investments lose money. When your asset starts losing, you tell yourself it’s nothing, you’ll be fine. If it keeps losing, worries start to sink in. “Have I gone wrong with this?” you start to think. If the downward trends continues your brain starts screaming “please get me out of here!”. Now you don’t care if you take the hit, you just want it to end. So, even when deep down you may know the current price is ridiculously low, you sell, nonetheless. You sell first, ask questions later. On a side note, behavioral finance also explains the other way round, when you were so euphoric (taking pleasure of watching the price go up almost every day) that you bought an asset even though you suspected it might have been overpriced (and so bubbles are formed in the first place).
• Ever heard of herd behavior?: Yes, that’s when we do things because others are doing it (we don’t think them ourselves). In marketing is it often called the “me too” effect. We prefer risking being wrong with the crowd than trying to be right all alone on our own. And it’s justifiable to ourselves and also others: “well, I did what everyone else did” (so don’t blame me).
• Market contagion: ok, if a poorly connected, small, emerging market crashes, developed countries probably won’t suffer. But the other way around will most probably be true. As herd behavior and fear run the show, geographic contagion on financial markets may take place, more than what numbers justify. Some drop may be justifiable, yes, as global economies are more connected now than ever. But sometimes a large part of it is merely unjustified overreaction. It’s due to the fear that in this market might occur the same, that investors sell preemptively, reaching a self-fulfilled prophecy.
• Margin calls might be another factor. In simple terms, when you invest on credit (that is, you borrowed money in order to invest it), you usually have to use some asset as collateral on the loan. If the investment starts going down in price and your collateral is shrinking, your creditor will issue a “margin call”, an instruction for you to replenish it. You may have to deposit additional funds or sell some of the invested assets, further spiraling the downward price trend. Investing on margin is therefore deemed procyclical.
• Open mutual funds might also be trend-fuelers. When prices start going down, investors may want to withdraw their money, forcing the open fund to sell assets to cover withdrawals, pushing prices even lower, in an ever-reinforcing trend.
• Stop loss orders: Wait, something designed to help me might actually be hurting me? Oh… yes. A stop loss order is a conditional selling order. It’ll do nothing, unless the price goes below a certain threshold, in which case will go active and try to sell your asset (at the current price, whichever that is). It was designed to cut losses short. If an asset you have starts losing, you want it out as fast as you can, right? One of the problems is that stop loss orders don’t guarantee an execution price. The price at which the order gets finally executed may be well below your set threshold. And there could be even a chain reaction: when your stop loss executes, it could drive the price even further, so now your fellow´s stop loss order (which threshold was set slightly lower than yours) goes active, spiraling the price down. “Ok, at least I outrun my neighbor” you may think, but what if you trading order gets executed way after a lot of prior orders, what selling price do you think you’ll get?. Can you picture Warren Buffett using stop loss orders? It violates a fundamental economic principle. It’s like saying “the less you offer me, more willing I’m to sell”. Now imagine a realtor quoting the house you live on lower every day. Will you go running to sell it before it keeps going down? It’s pinnacle nonsense. Remember we invest in businesses; we aren’t exchanging papers.
• Algo trading: algorithms, bots that try to outsmart the market by predicting the most recent trend, using orders, volumes prices and many other data. Now, suppose an algorithm detects a downward trend. So, it starts selling assets (because in the future they’ll trade for lower than now). As other algorithms start predicting the same trend, the rush in selling could propel in theory a never-ending equity wipe out. Safeguards must be put in place to prevent a self-fulfilling prophecy. Now, combine both algo trading with stop loss orders in the same mix, and you get the idea.

On one hand, market authorities usually implement circuit breakers. When panic starts to spread and drops are sharp, trading is banned for a period of time, to allow panic to subside, and to give time for the market participants to try to reach a consensus on a fair asset valuation, instead on “sell first and think later”. Thresholds are established: if the market drops more than X percent in X timeframe, a trade ban will be in order. Circuit breakers may help cut the reinforcing trends in the short term, and avoid widespread panic.

On the other, and perhaps more important in the long-term recovery, are fundamental investors. Those smart enough to look at valuations instead of short-term price trends. When stock valuation turns ridiculously low (say, a stock generates a great deal of cash compared to the stock price it currently sells for), fundamental investors go bargain-hunting, trying to buy as much as they can on the undervalued assets. The buying spree of major investors might be enough to reverse the trend of the panicked runners (who may end up losing a great deal to their wiser counterparts).

• Whenever panic spreads, do your best to keep a cool head. It doesn’t matter if everyone is in herd-behavior mode, or if your brain starts screaming “please I can’t take it anymore”. It’s in your convenience to forget about the stock price, and think in economic terms. Is the selling justified in valuation terms? Financial assets return isn’t magical, it should always be tied to the fundamental economics of the underlying enterprise below. If the price is taking a beat, but the underlying enterprise is as strong as before, the beating is unjustified. Price should go down in correlation with economic metrics. Say, if the long-term prospects of business deteriorate by 5%, then that should be more or less the price drop. If price drops, say 20%, is it clearly wrong. Also, remember that company valuations should reflect the long-term earning prospects. Not next year’s earning prospect, for that would be myopic. So, to justify a 20% stock price drop, the underlying long-term earnings power should drop 20%, and not just temporarily, but on a permanent basis. On a side note about thinking in economic terms, when someone offers you an asset that greatly increases in price with no underlying economic correlated increase (no earnings power improvement in the underlying economic enterprise), it’s probably either a scam or a bubble. In this latter case, your brain might be screaming “please let me buy it, everyone else is already making a million on it!”.
• Understand that offer and demand are mere proposals, based on perceptions. They don’t necessarily reflect the true intrinsic value of the asset. Otherwise, there wouldn’t exist over or undervaluation, nor extraordinaire returns for those who’re wiser.
• Keep an independent mind. You’ve an independent mind when you derive neither pleasure nor pain from being against the crowd. By staying independent you’ll sometimes play the role of the contrarian, doing exactly the opposite of what others are doing. Nathan Rothschild used to say “buy when there's blood in the streets” (that’s when everyone else is selling in panic). Being independent will help you both not losing your shirt when depression comes (selling an undervalued asset), as well as not entering the bubble when everyone else does (buying an already overvalued asset).
• Remember that from time to time a market correction may come. Don’t freak out. As Peter Lynch teaches, it’s like snow in winter. Just pick up your coat and keep on with your life. Trying to time the market, like predicting when will the snowfall come, may be counterproductive. You may end up losing the best one-day returns of the stock market (which account for most of the year gains anyway) by being out of the market. You may also pay more broker fees by buying and selling constantly. If fear of losing is overwhelming for you, then you probably shouldn’t be investing in the stock market to begin with.
• If the market valuation seems already high enough, abstain to invest in it. If payback requires many years, it’s probably not worth it. Look for an asset with a better valuation. If you’re already in the market and valuation doesn’t justify current prices, you might consider selling your stock, but before the market crashes, and not after! Risking to leave some money on the table is probably better than staying too long in a crazy party. General multiples and other fundamental metrics, could give you a sense of if the market in general is currently fair, under or overvalued. Try to assess the true intrinsic value of the underlying business. Focus on asset valuation, not timing.

If emotions could be taken out of the market, there would be neither crashes nor bubbles, but never-ending slight price adjustments. Void of panic or euphoria, prices wouldn’t change so much so rapidly either. So, the moral is to stay sensible.