What are Crashes and Bubbles?
A bubble is a type of investing phenomenon that demonstrates the frailty of some facets of human emotion. A bubble occurs when investors put so much demand on a stock that they drive the price beyond any accurate or rational reflection of its actual worth, which should be determined by the performance of the underlying company. Like the soap bubbles a child likes to blow, investing bubbles often appear as though they will rise forever, but since they are not formed from anything substantial, they eventually pop. And when they do, the money that was invested into them dissipates into the wind.
A crash is a significant drop in the total value of a market, almost undoubtedly attributable to the popping of a bubble, creating a situation wherein the majority of investors are trying to flee the market at the same time and consequently incurring massive losses. Attempting to avoid more losses, investors during a crash are panic selling, hoping to unload their declining stocks onto other investors. This panic selling contributes to the declining market, which eventually crashes and affects everyone.
Now that we’re familiar with the definitions of crashes and bubbles, we can look at how they occurred throughout history
The Tulip-Bulb Craze | When: 1634-1637 | Where: Holland
The amount the market declined from peak to bottom: This number is difficult to calculate, but, we can tell you that at the peak of the market, a person could trade a single tulip for an entire estate, and, at the bottom, one tulip was the price of a common onion. Synopsis: In 1593 tulips were brought from Turkey and introduced to the Dutch. The novelty of the new flower made it widely sought after and therefore fairly pricey. After a time, the tulips contracted a non-fatal virus known as mosaic, which didn’t kill the tulip population but altered them causing “flames” of color to appear upon the petals. The color patterns came in a wide variety, increasing the rarity of an already unique flower. Thus, tulips, which were already selling at a premium, began to rise in price according to how their virus alterations were valued, or desired. Everyone began to deal in bulbs, essentially speculating on the tulip market, which was believed to have no limits.
The South Sea Bubble | When: 1711 | Where: United Kingdom
The amount the market declined from peak to bottom: Stocks in the South Sea Company were traded for 1,000 British pounds (unadjusted for inflation) and then were reduced to nothing by the later half of 1720. A massive amount of money was lost. Synopsis: In the 1700s, the British empire was the big dog on the block, and that particular block spanned the entire globe. For the British, the eighteenth century was a time of prosperity and opulence, meaning a large section of the population had money to invest and were looking for places to put their money. So, the South Sea Company had no problem attracting investors when, with anIOU to the government worth £10,000,000.00, the company purchased the “rights” to all trade in the South Seas. The few companies offering stock at that time were all solid but difficult investments to buy. For example, the East India Company was paying out considerable tax-free dividends to their mere 499 investors. The SSC was perched on top of what was perceived to be the most lucrative monopoly on earth.
This success on the continent stirred British pride, and, believing that British companies could not fail, British investors were desperate to invest their money. They were blind to many indications that the SSC was run too poorly to break even (whole shipments of wool were misdirected and left decaying in foreign ports), and people wanted to buy even more stocks. The South Sea Company and others made a point of giving people what they wanted. The demand for investments caused IPOs to sprout out of everything, including companies that promised to reclaim sunshine from vegetables and to build floating mansions to extend Britain’s landmass. They all sold like mad. Eventually the management team of SSC took a step back and realized that the value of their personal shares in no way reflected the actual value of the company or its dismal earnings. So they sold their stocks in the summer of 1720 and hoped no one would leak the failure of the company to the other shareholders. Like all bad news, however, the knowledge of the actions of SSC management spread, and the panic selling of worthless certificates ensued. The huge hole in the south sea bubble also punctured the Mississippi Company’s unrealistic value and both came crashing down. A complete crash, which would be heralded by the folding of banks, was avoided due to the prominent economic position of the British Empire and the government’s help in stabilizing the banking industry. The British government outlawed the issuing of stock certificates, a law that was not repealed until 1825.
The Florida Real Estate Craze | When: 1926 | Where: Florida
The amount the market declined from peak to bottom: Land that could be bought for $800,000 could, within a year, be resold for $4 million before crashing back down to pre-boom levels. The prices were so inflated that to buy a condo-style property in 1926, you would’ve had to pay the same as you would now have to pay for a luxury home in the guard-gated communities in Miami ($4,500,000) – without adjusting for inflation! Synopsis: In the 1920s, the United States of America was chugging along like the British Empire of the 1700s, and it was only natural that people were beginning to believe such prosperity was infinite. But it wasn’t the stock market that was the recipient of a bubble. It was the real estate market. In 1920, Florida became the popular U.S. destination/residence for people who don’t like the cold. The population was growing steadily and housing couldn’t match the demand, causing prices to double and triple in some cases, which was not exactly unjustified at this point. But, news of anything doubling and tripling in price always attracts speculators. So, once people began pumping huge amounts of money into the real estate market it took off. Soon everyone in Florida was either a real estate investor or a real estate agent. Unfortunately, the rules are the same whether you pay too much for a stock or for a piece of land: you have to make that much more to claim a profit. This did happen for awhile, and land prices quadrupled in less than a year. Eventually, however, there were no “greater fools” to buy the disgustingly overpriced land, and prices began to adjust ever so subtly. Speculators realized there was a limit to the boom, and began to sell their properties to solidify their profits while they
could. Then everybody simultaneously saw the writing on the wall, and panic selling ensued. With thousands of sellers and very few buyers, prices came down with a sickening thud, twitched a bit, and then crawled down even lower.
The Great Depression (1929) – AKA Black Monday, Thursday, and Tuesday When: October 21, 24 and 29, 1929 Where: USA
The amount the market declined from peak to bottom: A string of terrible days led to a more than 40% drop in the market from the beginning of September 1929 to the end of October 1929. In fact, the market continued to decline until July 1932 when it bottomed out, down nearly 90% from its 1929 highs. Synopsis: Despite the Florida crash, Americans were as bullish as ever. The stock market was guaranteed to make everyone rich as the first world war had been won, and industrialization was resulting in previously-unimaginable luxuries. It was a good time to be American. Since the stock market was believed to be a no-risk, no-brain world where everything went up, many people poured all their savings into it without learning about the system or the underlying companies. With the flood of uneducated investors, the market was ripe for some manipulation and swindling. Investment bankers, brokers, traders, and sometimes owners banded together to manipulate stock prices and get out with gains. They did this by subtly acquiring large chunks of stock between them and trading them between each other for slightly more each time. When the public noticed the progression of price on the ticker tape, everyone would buy the stock. So, the market manipulators would then sell off their overpriced shares for a healthy profit. On and on the cycle went as uneducated investors turned a profit by selling the manipulated, over-priced shares to someone who wanted to have a rising stock. Behavioral finance shows that the less an investor knows, the easier it is for him or her to be swept up in popular opinion (herd mentality). This behavior is a double-edged sword because the ignorant investors are also easily spooked into panic. Both actions, joining and fleeing, have very little basis in the quality of the news or the quality of the market. Instead, the herd follows the cow that runs the fastest, trampling the market.
During the craze before the Great Depression a number of academics, including Roger Babson, were predicting a crash if things didn’t “calm the hell down.” Sadly, for every Roger Babson, there were four bull-blinded academics guaranteeing the eternal rapid growth of the American stock market. Although Babson had been predicting the crash for years, the capricious and ignorant investors finally listened. The twelve-year worldwide depression came and ended only with the declaration of war. This stands as the worst financial blow to the USA ever. The crash itself, though large in its own right, was nothing compared to the ensuing graveyard market and devastating depression.
The Dot-Com Crash
When: March 11, 2000 to October 9, 2002 Where: Silicon Valley (for the most part)
Percentage Lost From Peak to Bottom: The Nasdaq Composite lost 78% of its value as it fell from 5046.86 to 1114.11.
January 2008 Sub-prime Crisis and Global Stock Market Crash
Hundred of Us Banks went bankrupt. Most Global Markets had lost 50% of their value from the peak. And as usual economic depression followed which is still continuing in some parts of the world.
keep yourself educated, informed, and well-practiced so that you are always able to recognize such events before everyone else does and save yourself from losses that may arise following such crashes.
Happy Investing!
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