Booms and Crashes

Newbies and those unfamiliar with shares, may feel concerned about one particular infrequent but well publicized stock market event – a crash. There’s no need to fear a crash. A little understanding can go a long way towards unveiling the mystique. Here’s the story of some famous booms and crashes.

Tulipmania

The tulip was introduced to Europe around the middle of the 16th century. They increased in popularity amongst the wealthy until 1634 when the Dutch middle classes caught onto the craze. At that time it was considered bad taste for a person of means not to own a number of bulbs. The popularity of the flower spread to London and Paris where they were traded on the exchange, however no-one went as far as the Dutch. By 1636 regular markets for trading tulips were established on many stock exchanges throughout Holland.

People began to sell land and property at bargain basement prices to speculate on the tulip market. At the height of the mania, one person offered 12 acres of land; another sold a single bulb for 4,600 florins, a new carriage, two horses, and a complete set of harnesses. Depending upon the story, the highest price paid for a tulip bulb was up to the equivalent of $100,000 in today’s terms.

By late 1636, people began to see the foolishness of prizing an ornamental flower so highly. Panic set in, prices plummeted and defaults on promised purchases became a regular occurrence. Judges refused to enforce payments on the premise that gambling debts were not debts under the law. It took many years for the economy to recover from the loss of confidence.

South Sea Bubble

The South Sea Company (SSC) was established in England in 1711 to support a group of merchants who had offered to secure the government debt. Duties from imported goods were made permanent to pay for the 6% interest promised to the merchants, as well as being granted a monopoly of trade to the South Seas.

Everyone was aware of the gold and silver mines of Peru and Mexico, and the imagination of the crowd caught fire. During the time that the company was putting forward their proposal to fund the government debt (in competition with the Bank of England) it is reputed that shares in the company rose from 130 pounds to over 300. Speculation in the stock became commonplace and demand for shares overflowed into other companies and start-ups. These companies were given the name ‘bubbles’ at the time, quite appropriate as hindsight shows.

By May 1720, stock in SSC had risen to 550 pounds; it then jumped to 890 pounds in four days at the end of May where the stock peaked! By September the stock had fallen to 135 pounds and continued down until Early 1721 when the company was wound up and shareholders were paid a dividend of a little over 33 pounds.

The first actual voyage of SSC didn’t take place until 1717, and the Spanish naturally, never intended to give the English free trade in the ports of Spanish America. The whole scheme of paying off government debt through trade in South America was doomed to fail. The directors of the company were found guilty of fraud as they sought to raise the stock through fictitious reports.

1929, 1987 and 2008

A speculative frenzy has taken stock markets by storm regularly in the past. In the final two years of the boom prior to the inevitable return to reality, stocks can rise over 80% or more. The 1920’s crash was at least partly, if not primarily, a result of buying on margin. That is, the trader paid a small percentage of the cost (as low as 3% in some cases) and the brokerage firm or bank supplied the rest on loan.

In essence people were buying more shares than they could afford, thus supplying artificial demand to the market. Margin loans were again popular up until late 2007, and were responsible for terrible losses for some investors during the severe falls in 2008. During the 80’s boom, takeovers and corporate deals ignited share fever. The next boom and crash will naturally have its own characteristics. Ultimately however, reality forces itself upon any illusion and markets fall back to earth.

Between 1929 and 1932 the Dow lost 89% of its value, the 1987 crash consisted of a fall greater than 50% in a week and the fall from the market top in November 2007 to March 2009 was 55%.

There have been many other crashes such as the 90’s tech-wreck. However, I have raised this issue for the purpose of education and understanding – forewarned is forearmed. Many people, uninitiated to the ways of share market, fear being caught in a crash. However, all crashes have something in common.

First, there is a huge and rapid gain in price before the event. Secondly, the particular investment in question becomes part of crowd psychology. Everyone has heard of it, and practically everyone is involved and/or talking about it. Stories of fantastic riches usually abound to spur people on and activate the greed factor. Prices move up to nonsensical levels as people fear missing out and jump on board in the heat of emotion. These are the signs of impending doom.

It’s exactly the same in real estate where the only difference is it takes a lot longer to unfold. If you doubt this, have a look at the residential property scene in the USA since 2006 and Japan over the last 20 years.

To avoid investing and trading because of the fear of a crash is much like avoiding driving for the same reason. Many worthwhile advantages are missed because of the fear of a relatively uncommon event which the properly trained person will avoid anyway. In addition, just because one does not drive, does not mean one will not be affected by a car accident - the same applies to the stock market.

In a crash, the whole economy is affected, including every person, even those who do not hold shares. It is far better to learn and gain the understanding necessary to trade markets successfully. In this way, one can control the risks through the knowledge gained.

Even more importantly, you can learn how to profit on a falling market, thus turning a market collapse into an opportunity. With knowledge, the risks can be controlled and thus the benefits enjoyed. We MUST know when to sell and then SELL and that’s much simpler than most people think.