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How Markets Crash

 12 min read / 

On October 19, 1987, ABC halted the airing of General Hospital with the words, “interrupting our regularly scheduled programming to bring you a special report.” Soon after, news anchor Peter Jennings was reporting the Dow Jones Industrial Average (DJIA) tremendous drop.

Known as Black Monday, the Dow Jones Industrial Average plunged over 20% within a few hours. Once graphed, the pattern revealed startling similarities with the first Black Monday of 1929. The one credited with ushering in the Great Depression.

When that October day of 1987 was over, stock markets had fallen by 45.5% in Hong Kong, 41% in Australia, 31% in Spain, 26.45% in the United Kingdom, 22.68% in the United States, and 22.5% in Canada, making it a truly global event.

Fast forward to September 29, 2008, the Dow Jones Industrial Average (DJIA) fell 777.68 points in intraday trading.

Two weeks earlier, on a Monday, Lehman Brothers declared bankruptcy. Tuesday of the same week opened with the Fed announcing it was bailing out insurance giant AIG. On Wednesday, money market funds lost $144bn as companies moved their money to Treasury Bills due to increases in LIBOR rates.

LIBOR, the London Interbank Offered Rate, is the rate banks agree upon to lend money to each other. It is a wholesale interest rate and has a major impact on most of finance. During that time in 2008, banks were afraid to lend to one-another, raising the Libor as a reaction to this risk.

The “flash crash” of May 6, 2010, occurred as the result of computer trading software reacting to changing market conditions. The Dow Jones Industrial Average lost 1000 points in 10 minutes. The largest to date.

On August 22, 2013 trading was halted on Nasdaq for over three-hours when computers from the NYSE could not process pricing information. Then on May 18, 2012, during the Facebook IPO, a computer error prevented the Nasdaq from accurately pricing shares of the new stock.

Most recently, on February 5, 2018, US stocks plunged for twenty-minutes. This was a smaller yet similar pattern to the May 2010 crash. Dennis Debusschere, head of portfolio strategy at Evercore ISI, described it as, “[a] withdrawal of stock orders [that] rapidly exacerbates price declines.”

The First Crash

The first recorded crash – 1929 – was a four-day event where the market lost the equivalent of $400bn. It signalled the beginning of the Great Depression. This subject has been studied ad nauseam. However, it is important to realise the major factors involved.

For many years, people had been enjoying a rapidly expanding market. Prices kept moving upward and many borrowed money from their stockbrokers to buy more than they could afford. The US Treasury Secretary during the incident, Andrew Mellon, stated in an interview that “people acted as if the price of securities would infinitely advance.”

Newspapers like the New York Times exacerbated the resulting panic by running a news story claiming foreign investors are leaving the market. The Washington Post reported drops in the “ultra-safe” utility stocks and a story titled “Huge Selling Wave Creates Near-Panic as Stocks Collapse.”

After the market failed, the stockbrokers called in their loans. This resulted in the closure of many businesses, including banks – an event that became the catalyst for the resulting depression.

Markets and LIBOR

One should remember that a big component of the 1929 crash was businesses and small banks borrowing money from their brokers to invest. Turns out that big banks still do the same thing by lending money to one-another.

As previously mentioned, LIBOR is the rate at which they lend to one another. These are in the form of overnight, one-month, three-month, six-month, and one-year loans. It affects how banks invest, as well as what they charge for adjustable rate loans.

In 2008, banks and hedge funds were using LIBOR as a hedge against mortgage-backed securities. This was in the form of credit default swaps. When the Fed bailed out Bear Sterns, banks panicked due to their similar holdings in subprime mortgages. As a result, banks stopped lending to each other for several months.

Banks were afraid of the subprime mortgage holdings. Believing some of the bank-to-bank lending would be used to hide such investments, LIBOR rates climbed. The October 3, 2008, US Senate bill for $700bn in bank bailouts was used to reduce the LIBOR rates by erasing the bad investments from the banks and hedge funds.

Politics aside, the point is that when a large number of banks make risky investments in similar assets, it can cause repercussions across all aspects of market activity. For example, if interest rates increase, people are forced to buy less.

While saving is prudent for individuals, most consumer transactions are based on debt. Automotive, housing, banking, electronics, and clothing are all industries reliant on low-cost consumer financing. If people cannot borrow, then they are unable to buy. If everyone decided to be debt free within a short period of time, the economy would fall.

The 1950s

Most of modern society began in the 1950s. It was a time when soldiers back from World War II were given government-backed mortgages in the form of the GI Bill. Savvy home builders were booming as demand for homes hit an all-time high.

Unlike previous generations, these young adults were not afraid of debt. As a result, the standard of living rose dramatically. They bought cars their parents only dreamed of and lived in houses much nicer than the previous generations.

As individual savings went down, companies were introducing franchising. A means to sell copies of successful businesses all over the country. McDonald’s was the first. Followed by Howard Johnson’s motel chain. The result was rapid growth on a scale never before possible.

The mix of consumers unafraid of debt and a boom in franchising resulted in a massive growth in lifestyle. Unlike the past, most workers could purchase many luxuries. As a result, cars became more expensive, houses grew larger, and businesses expanded quickly – a trend that continues to this day.

Bretton Woods

On August 15, 1971, the United States backed out of the Bretton Woods Accord, the result of a 1944 gathering of 44 countries in Bretton Woods, New Hampshire, where an international agreement among countries monetary policy was reached. The dollar was named the world’s currency benchmark and multiple United Nations controlled financial institutions created.

After the United States’ exit from Bretton Woods, the dollar was removed from the gold standard, meaning all of its value is now based on supply and demand.

Political instability marked the decade, starting with the US support of Israel during the 1973 Yom Kippur War that led to an oil embargo from Arab producers. This embargo also included Great Britain, Canada, Japan and the Netherlands.

The decade ended with Cold War tensions between East and West global powers, a shift to Japanese electronics, higher social security taxes for those in the United States, and an economic recession.

The 1987 Crash

During the 58 years between the 1929 crash and 1987, multiple global events transpired. There were two World Wars, a Korean War, and the Vietnam War. The rise of United Nations monetary controls and the US exit from them along with the removal from the gold standard. Yet, despite financial turmoil, there were no market crashes.

In the late 1970s, startup companies with no credit issued bonds as a means of financing growth. Since these were poorly rated due to a lack of credit history, the term “junk bond” was used. As a compensation for the added risk, the issuing companies offered higher returns.

This was an early alternative to venture capital. A young company could borrow money without risking the personal assets of the founders. During the 1980s these junk bonds were a common investment tool. Michael Milken, a trader at Drexel Burnham Lambert, even used junk bonds to finance hostile takeovers.

Another shift was the use of computer trading. Mainframe computers made up an estimated 10% of trading during 1987. While painstaking in design, the algorithms used on those systems were created based upon standard procedures. Meaning if the market did the unexpected, the computer would not handle it gracefully.

When conditions to sell hit that day, every computer started selling. All liquidating assets at the same time. Human traders noticed the fall in price and panic soon followed. DuWayne Peterson, vice president of systems, operations and telecommunications at Merrill Lynch stated, “we had no idea what we’d walk into that Monday morning.” The crash was not limited to one market but impacted the stock, futures, and options markets.

“This event illustrated the weaknesses of the trading systems themselves and how they could be strained and come close to breaking in extreme conditions,” concluded the Fed. However, it was not just the computers who were at fault. “The boom that the October 1987 crash ended was a takeover boom, funded by junk bonds,” wrote Malcolm Maiden, financial correspondent for The Sydney Morning Herald.

Noise and Gambler’s Fallacy

After getting a brief overview of almost 90 years of market history. It is easy to see the factors involved with creating a market crash. History repeats itself as is the case with 1929, 1987, 2000, and 2008. All of those crashes had multiple similarities.

Each market crash came after a period of market growth. During such periods, investors become relaxed by the market’s positive trend, thus experiencing a false sense of security in regards to market behaviour and perceived risk. During the 1950s, the economy blossomed, and it proved almost impervious to logic during the 1960s and 1970s. The market survived political upheaval, unpopular wars, and even a recession without a crash.

In 1929, people had borrowed money to invest due to the expected growth. During 1987, participants invested in risky bonds after learning of the wealth they created. Just before the year 2000, investors speculated heavy in unproven companies due to sensational news stories of overnight millionaires. Then in 2008, the frenzy of subprime mortgages exploded but not before most investors went all in.

The point is that in each of these cases, there was a period of prosperity that brought about a form of mass gambler’s fallacy. This is the false belief in the ‘hot hand’ (the expectation of future winnings due to past performance). It could be a series of blackjack wins, successful dice rolls, or slot machine jackpots. With markets, it is as if everyone at the casino is winning. The more this occurs, the more risk people are willing to accept. That is until someone starts to lose. Then the panic begins.

Economist Fischer Black concluded in his 1996 paper that “a disproportionate amount of trading occurred on the basis of noise, rather than evidence.” The noise is trending news, apparent increases or declines in prices, and word of mouth speculation. When a majority of market participants rely upon emotion, the market is at risk for a crash, something often exacerbated by the news media.

Using the casino metaphor, one should consider what happens as a room full of players begins to lose after a long period of wins. One loss becomes two then three then four. Soon, other players are loosing too. However, they keep playing because of the original winning streak, believing that somehow they will earn back the losses. Instead, they squander the winnings.

Promotions and Computers

If a market is trending upward due to the work of promotion watch out. This happened in 1929, with stockbrokers loaning money. It occurred again in 1987 with junk bonds, then again in 2008 with subprime mortgages.

What happens is this: a group of salespeople begin touting an idea to big money clients such as banks and funds. This group uses public relations and even political lobbyists to assist with pumping up that market, such as news stories on junk bond takeovers or bills to assist people with home ownership.

As the noise grows, smaller investors want to play too. This ensures a steady increase in profits for those already invested. However, there is a tipping point where the noise is no longer heard. Once the hype goes away or worse, changes direction, the market reverses.

When prices change in today’s electronic traded markets, the computers make changes to their holdings. This can cause a dramatic rise or fall in prices within minutes — such as the 20-minute drop of February 5, 2018 – resulting in panic that can trigger a series of tragic events.

Panic and Profit

When markets go bad, the majority of investors panic. The noise of news outlets with public outcry, dramatic dips on chart prices, and stories from friends and neighbours tend to create a frenzy of selling.

In 1929, everyone sold because of panic from the news media. In 1987 and 2008, everyone sold because computers were selling. When the average person sees their savings going away, their first thought is to stop the loss. If the loss is great enough, they may exit the market altogether. This can cause a crash to occur.

On a side note, when prices drop dramatically, savvy investors such as Warren Buffett and George Soros go on a shopping spree – not for consumer goods, but for assets and companies currently available for pennies on the dollar.

The smartest investors never panic. Because there is always a way to make money from a market, usually not from the direct asset being unloaded, but from those other assets that are caught up in the fear frenzy.

Conclusion

Market crashes occur due to noise created by one position changing direction and supporting another. This is exacerbated with computer trading, news media, and dramatic changes in pricing – resulting in panic.

Crashes occur not from a single asset going out of favour, but from a loss of faith in an entire market. The 1929, 1987, and 2008 crashes all resulted in a loss of trust for entire markets. This is also why the 1973 oil embargo did not crash the market. It hurt those tied directly with oil, but other industries like electronic manufacturing did well.

This is the reason that bitcoin has never crashed – it is a single asset and not a market. The entire block of cryptocurrencies is the market and so far, nothing has changed the public’s opinion on them as a whole.

As algorithmic trading, machine learning, and greater reach of ideas due to internet technology increase, the risk of market crashes will increase. However, the same factors that cause them can help to resolve them.

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