Market Crash - Research Paper Example

 MARKET CRASH Abstract The investment climate necessarily must foster a feeling of trust and confidence among investors in order to facilitate the free flow of capital. However, there are events that compromise this trust, known as market crashes, wherein investors tend to lose a substantial proportion of the value of their investment. Crashes apparently occur despite the knowledge that has been gathered about economic and financial cycles and activity, the most recent of which occurred in 2008 and is still unfolding. The subprime mortgage crisis in the U.S. has not only plunged the country’s financial markets into their most volatile trading and deepest plunge since the crash of 1929, but also promises to usher in what others are now calling the Second Great Depression. There is a flurry of research and speculation to understand the causes, extent, and remedies that may be applied to market crashes, the goal to which this paper is devoted. THE NATURE OF ASSET BUBBLES AND MARKET CRASHES Stock market crashes are momentous, financial events that are caused by a revelation of a dramatic piece of information that has so far eluded the “efficient” market (Sornette, Didier, p. 3, Princeton University Press). A crash is created by the situation wherein the majority of investors are trying to flee the market at the same time, thereby selling off to lower and lower buyers’ prices and incurring massive losses as a consequence (Investopedia, http://www. investopedia.com/features/crashes/). A crash typically occurs after the acceleration of the market price, called the “bubble,” wherein the rate of price increase is pronouncedly much greater than the asset’s appreciation in true value as to be justified by it (Sornette, Didier, p. 3, Princeton University Press). A bubble has also been defined as a type of investing phenomenon that demonstrates the frailty of some facets of human emotion; it occurs when investors put so much demand on a stock that they drive the price beyond an accurate or rational reflection of its actual worth based on the underlying company (Investopedia, http://www. investopedia.com/features/crashes/). A crash is an event that is inevitable when the market has progressed into an unstable phase, such that any small disturbance could possibly trigger a collapse; the instantaneous cause of the collapse is not so significant as the condition of instability that had placed the market in its precarious position to begin with – “the systemic instability” (Sornette, Didier, p. 3, Princeton University Press). The U.S. stock market crash of 2008 is graphically depicted by the S&P 500 daily price chart on the next page. Source: http://www.qqq-options-trading.com/images/bl/stock_market_crash_2000_2008.GIF MARKET CRASHES OF THE 20TH CENTURY Real estate market crash of 1926, Florida – In 1920, Florida became the popular U.S. destination for people searching for warmer climes, and believing that prosperity brought by the recent economic boom was infinite, bought up property prices to double or even triple their original values (Investopedia, http://www.investopedia.com/features/crashes/). Stock market crash of October, 1929, Dow Jones Industrial- Despite the collapse of the real estate bubble in Florida, Wall Street experience on the 28th of October, 1929, the plummet by the Dow Jones Industrial Average by 12.8%, followed by a further 11.7% on the day following (Arnold, James, http://news.bbc.co.uk/2/hi/2131739.stm, BBC News). Stock market crash of October, 1987, Dow Jones Industrial - On 19 October, 1987, otherwise known as “Black Monday,” the value of the US market declined by almost one-fourth within the space of a few hours (Arnold, James, http://news.bbc.co.uk/2/ hi/2131739.stm, BBC News). It was the stock market that was caused by an overly bullish sentiment created by the images projected by underlying companies, in spite of poor financial reports submitted in compliance with SEC requirements; the SEC was unable to halt the shady IPOs and conglomera-tions, resulting in the bubble before the crash. (Investopedia, http://www.investopedia.com/ features/crashes/). Japanese economic crisis of 1989 to present, Nikkei – The Japanese economy lost 63.5% of its value from 1989 until 2003, and the causes of the crisis is still ongoing, with the initial crash of the Nikkei morphing into a massive bear market (Investopedia, http://www. investopedia.com/features/crashes/). Extreme investor optimism of the recovering Japan economy after the war and emergence of new technological manufacturing concerns made trading a national sport and pushed up asset prices to unjustifiable levels (Investopedia, http://www.investopedia.com/features/crashes/). Stock market crash of October, 1997, Dow Jones Industrial - On the 27th of October, 1997, a basically bullish market succumbed to worries over the Asian bubble collapse, plunging 550 points in one day and being checked only by a “circuit-breaker” system established after the crash in 1987 ((Arnold, James, http://news.bbc.co.uk/2/hi/ 2131739.stm, BBC News). The Dot Com stock crash of March, 2000, Nasdaq – On March 11, 2000 and for the next two years, the Nasdaq composite index lost 78% of its value, falling from a peak of 5,046.86 to a low of 1,114.11 (Investopedia, http://www.investopedia.com/features/crashes/). Internet companies were booming and the investors were caught in the excitement of the “new economy;” their over-exuberance in the face of a business the valuations of which were largely speculative created a “dot com” bubble (Investopedia, http://www.investopedia.com/features/crashes/). LINK BETWEEN MARKET CRASHES AND ECONOMIC DEPRESSION The important distinction is between simple crashes or “black days” where the index recovers almost immediately after, such as the 1997 crash, and an all-out bear market such as the 1929 event that began a prolonged decline in prices and signalled the Great Depression that lasted the greater part of the next two decades (Arnold, James, http://news.bbc.co.uk/2/hi/ 2131739.stm, BBC News). Others begged to differ, describing the relationship of bubbles and crashes as similar to the relationship between clouds and rain, indicating a closer causal relationship (Investopedia, http://www.investopedia.com/features/crashes/). Long-term data garnered from 25 countries reveal that there have occurred 195 stock market crashes (defined as multi-year real return of negative 25% or less) and 84 depressions (defined as multi-year macroeconomic declines of 10% or more), with 58 cases matched by timing (Barro, Robert J. & Ursua, Jose F., http://weber.ucsd.edu/~jlbroz/PElunch/barro_ursua_ stock_ crashes.pdf, National Bureau of Economic Research). 45% of matched cases of crashes and depressions are associated with war; in a non-war environment, 20% of the crashes are matched with a minor depression, and 3% for crashes matched with a major depression (Barro, Robert J. & Ursua, Jose F., http://weber.ucsd.edu/~jlbroz/PElunch/barro_ursua_stock_ crashes.pdf, National Bureau of Economic Research). From the data, it is apparent that a market crash signals a depression of 10% or more by a probability of 69%, and a depression of 25% or more by a significant probability of 91% (Barro, Robert J. & Ursua, Jose F., http://weber. ucsd.edu/~jlbroz/PElunch/barro_ursua_stock_ crashes.pdf, National Bureau of Economic Research). CAUSES OF THE PRESENT FINANCIAL CRISIS A long-festering cause of the financial crisis is the era of unregulated financial markets that has allowed irresponsible greed to fuel the market’s recent bubble (Schmudde, David, p. 709, Fordham Journal of Corporate & Financial Law). Huge and increasing amounts of home mortgages, often based on weak underwriting including no downpayment or checking credit histories, were given to individuals and families that clearly could not afford them, which caused the massive defaults as interest rates rose (Salvatorre, Dominick, http://www.geam.com/common /newsdocs/The_Financial_Crisis-CEPRIS.pdf, GE Asset Management). EFFECTS OF THE FINANCIAL CRISIS As a result, stock markets crashed all over the world, with declines ranging from 35-40% over the past 12 to 18 months in developed economies and even more in emerging markets, as well as distortions in foreign exchange rates (Salvatorre, Dominick, http://www.geam.com/ common/newsdocs/The_Financial_Crisis-CEPRIS.pdf, GE Asset Management). REFORMS TO PREVENT FUTURE CRISES Important reforms to prevent future crises need to be comprehensive but also broad and general, because inadequate regulations on investment banking and improper application of existing regulations contributed to the financial crisis (Salvatorre, Dominick, http://www.geam. com/common/newsdocs/The_Financial_Crisis-CEPRIS.pdf, GE Asset Management). Regulations most importantly should restrict or prohibit the trading of exotic derivatives to close avenues of creative financial excess; these are derivative financial instruments for which the correct price is difficult or impossible to determine, which sellers cannot clearly explain or buyers cannot clearly understand how they are supposed to work (Salvatorre, Dominick, http://www.geam.com/ common/newsdocs/The_Financial_Crisis-CEPRIS.pdf, GE Asset Management). SUGGESTED AREAS FOR FUTURE RESEARCH In the academic inquiries conducted so far, the relationship between asset bubbles and crashes in various markets (such as the real estate bubble in Florida in the 1920s) indicate that the price bubble is a reliable precursor to a market crash. The development of bubbles does not happen overnight, but in years or even decades, to such extent that it is sometimes difficult to differentiate a bubble from solid economic growth. In the present crisis, it took nearly a decade – mainly within the eight years of the Bush administration – for the mortgage sub-prime market to develop a bubble. The difficulty lies in human perception, particularly the onset of unfounded optimism, even irrational exuberance, at the ease by which past gains had been acquired, which prevented many investors from recognizing the presence of unjustified price increases. There is thus a strong need for academic inquiry to delve into objective indicators that could signal that a bubble is currently in progress. Statistical or financial quantitative measures of price changes, their proportional movements and momentums, may provide a clue to this end. Also, the role of market psychology in the collective emotional attitudes of investors, and their perception of risk (pessimism) and opportunity (optimism) in periods of volatile trading should also be the subject of future research. Among practitioners, much emphasis is placed on trading discipline through goals identification, and contrarian perception – greater caution and more defensive positioning – during times of accelerated market surges is a restraint lost upon the mass of investing public. A study on these phenomena should provide important input for policy. Finally, further studies should treat on the relationship between the occurrence of market crashes and the development of a subsequent recession or depression. Studies have sometimes differentiated between the two, and sometimes confirmed their matching. Knowing how a crash affects the following bear market and economic drop could aid in preparations for the long haul. BIBLIOGRAPHY Arnold, James, http://news.bbc.co.uk/2/hi/2131739.stm, BBC News Barro, Robert J. & Ursua, Jose F., http://weber.ucsd.edu/~jlbroz/PElunch/barro_ursua_stock_ crashes.pdf, National Bureau of Economic Research Investopedia, http://www.investopedia.com/features/crashes/ Salvatorre, Dominick, http://www.geam.com/common/newsdocs/The_Financial_Crisis-CEPRIS.pdf, GE Asset Management Schmudde, David, pp. 709-770, Fordham Journal of Corporate and Financial Law Sornette, Didier, p. 3, Princeton University Press Read More