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The Last Three Stock Market Crashes. Can Boom and Bust Be Predicted?

by Arthur Ritter (Author)

Seminar Paper 2014 12 Pages

Business economics - Investment and Finance

Excerpt

Content

2 INTRODUCTION

3 STOCK MARKET CRASH IN 1987 - BLACK MONDAY
3.1 CAUSES

4 THE STOCK MARKET CRASH IN 2000 - .COM BUBBLE
4.1 CAUSES

5 THE STOCK MARKET CRASH IN 2007 - THE MORTGAGE CRISIS
5.1 CAUSES

6 COMPARISON AND CONTRAST
6.1 COMPARISON
6.2 CONTRAST

7 CONCLUSION - CAN BOOM AND BUST BE PREDICTED?

8 BIBLIOGRAPHY

2 Introduction

Stock market crashes had occurred in the financial market since the very beginning and in every generation (Sornette, 2003a). “Greed, hubris and systemic fluctuations have given us the Tulip Mania, the South Sea bubble, the land booms in the 1920s and 1980s, the U.S. stock market and great crash in 1929, the October 1987 crash, to name just a few of the hundreds of ready examples “ (Sornette, 2003a, p. 7.). This essay will compare and contrast the last three major stock market crashes in 1987, 2000 and 2007. To do this, the essay will pay special emphasis on the causes of the three crashes. From there the essay will draw out the similarities and differences and will answer the question if boom and bust can be predicted.

3 Stock Market Crash in 1987 - Black Monday

The stock market crash in 1987, which is also called Black Monday, took place on Monday, October the 19th 1987. During that single day the Dow Jones Industrial Average (DJIA) had plummeted by 22.6% (Hubbard, 1991). This plummet, however, was only the tip of the iceberg. During October 14th to 16th the DJIA fell by more then 10%, which is more than “any one-, two-, or three-day decline since May 13-14, 1940 “ (Mitchell & Netter, 1989, p. 38.). In addition, the financial markets in all major industrial nations dropped on a substantially scale. 19 out of 23 industrial countries “had a decline greater than 20% (Sornette, 2003a, p. 6) .

3.1 Causes

Since the crash in 1987, a lot of research had been carried out to explain the crash and what really triggered it. Today, though, it is still not completely clear what caused the enormous decline. Sornette, D. mentions fife essential reasons for the crash in 1987, computer trading, derivate securities, illiquidity, trade and budget deficits and overvaluation (Sornette, 2003a).

1. Program trading

The financial markets, especially within the Wall Street, have seen a strong increase in program trading over the last years. Computers were programmed in a way to automatically sell or buy stocks if certain market conditions occur. These automatically triggered sell or buy orders where blamed to have initiated a domino effect after the decline of the previous days (Carlson, 2007).

2. Financial Innovation and Deregulation

The rise in derivate trading caused a rise in volatility in the stock markets, which increases the “variability, risk and uncertainty “ (Sornette, 2003a, p. 6) . Overall deregulations supported the increase in trading with high-risk financial products (Sornette, 2003a).

3. Illiquidity

The illiquidity of the market intensified the drop in share prices since there was just not enough money in the market for all the market participants who wanted to sell their shares (Sornette, 2003a).

4. Trade deficit

The large trade and budget deficit in the United States could have made investors expect a decline in U.S. stocks since a trade deficit is usually followed by a decrease in value of the currency and a higher potential for inflation (Sornette, 2003b).

5. Overvaluation

Over the fife years before the “Black Monday” share prices have risen sharply. The rise in share prices was no longer in proportion with the increase of profitability and business growth. This lifted price/earing ratios to a very high level (Carlson, 2007).

All in all, the current opinion on what caused the crash is a combination of the reasons mentioned above. The increased amount of trading with derivatives and the program trading lifted the volatility and risks to level never seen before. The relatively bad macroeconomic circumstances, the overvaluation of the shares and the illiquidity of the market caused the plummet after the decline right before October 19th. So it can be assumed that the arrival of fundamental news triggered the market to initially decline and “this significant market decline changed traders’ view of the viability of dynamic trading strategies, which affected market operations, causing a downward revaluation of stock prices and leading to a ‘‘crash’’ on October 19“ (Baigent & Massaro, 2009, p. 136).

4 The Stock Market Crash in 2000 - .com Bubble

The stock market crash in 2000 can be primarily attributed to the bubble in the New Economy. The overall economy in the United States (U.S) was booming in the 90s with a decrease in inflation, unemployment and an increase in economic growth and productivity (Kindleberger & Aliber, 2011). However the rapid growth rates in the U.S. stock markets, especially in the Nasdaq composite index (the index for technology stocks), and the associated inflow of capital caused the U.S. dollar to appreciate. The appreciation of the U.S. dollar caused a trade deficit of $500 billion and decreased the domestic saving rate to a record low (Kindleberger & Aliber, 2011). The .com Bubble grew over the 1990s and reached its absolute size on March 10, 2000, with the NASDAQ peaking at 5,132.52 (Google Finance, 2014a). Over the next following months the NASDAQ declined sharply and the bubble busted. “Between August 2000 and December 2001, the Dow Jones dropped approximately 11 percent, the S&P500 fell 23 percent and the NASDAQ nearly 49 percent” (Mishkin & White, 2002, p. 30).

Abbildung in dieser Leseprobe nicht enthalten.

FIGURE 1: INTERNET STOCKS COMPARED TO NON-INTERNET STOCKS

Source: Sornette & Woodard, 2010,

The main influencing factors are described in the following:

4.1 Causes

1. Overvaluation

One of the main explanations for the occurrence and the burst of the .com Bubble was the significantly overvaluation of the high tech stocks. Between 1998 and 1999 the Standard & Poor’s technology sector grew by almost 400% while the old economy, represented by the S&P 500, increased only by 50% (Sornette, 2003a). The new economy stocks were absolutely overvalued with “price-over-dividend ratios, often ( … ) in three digits prior to the crash” (Sornette, 2003a, p. 269). All in all, we can say that the drastic increase in the new economy was “as fuelled by expectations of increasing future earnings rather than economic fundamentals ” (Sornette, 2003a p. 270).

2. Financial Innovation

The new boom of online trading with substantially low transaction costs generated a new group of traders, some of which had almost no experience in the stock market. This technical revolution brought millions of new entrants in the market who also wanted to participate form the rising rates of high tech stocks. However they only encouraged the bubble to burst (Kindleberger & Aliber, 2011).

3. Justification by new business models

New business models like “the network effect, first-to-scale advantages, and real options effect” (Sornette, 2003a, p. 270) tried to justify the overvalued new economy stocks. The core explanation that the current values were that capital investments supposed to be much lower compared to traditional companies and that they could “generate cash from working capital“ (Sornette, 2003a, p. 270) due to new online payment methods. These justifications attracted even more investors to invest in the new economy.

To sum up, the main reason for the stock market crash was the .com bubble in the new economy. The NASDAQ was totally overvalued and the growth was mainly based on expectations rather than fundamental data like real cash flows.

5 The Stock Market Crash in 2007 - The Mortgage Crisis

The triggering date of the stock market crash in 2007 can be set to the beginning of 2006 when the house prices in the U.S. started to decline (Acharya, Philippon, Richardson, & Roubini, 2009). After peaking in Oct 12, 2007 at 14,093.08, the DJIA declined more than 52% until Mar 06, 2009 (Google Finance, 2014b). The main causes for the stock market crash and the following financial crisis can be described as the following:

5.1 Causes

1. The Housing Bubble

The housing price index form 1890 to 1997 showed an average growth rate of 2,9%, in comparison, the average growth rate from 1998 to 2007 was 9,3%. Adjusted by inflation, the real housing price index rose by 6,8% a year from 1997 to 2007 and only showed an average increase of 0,086% per year between 1890 and 1997 (Kaizoji, 2010). The bubble in the real estate market in the U.S. and other industrial countries was driven by very low interest rates, which encouraged consumers to invest in real estate markets (Diamond & Rajan, 2009). In addition, a lot of investments from emerging countries flew into the U.S. and European markets, “leading to excess liquidity, low volatility and low spreads“ (Acharya, Philippon, Richardson, & Roubini, 2009, p. 98). Moreover, the relatively new method of securitisation for mortgage-underlined securities, which will be discussed in more detail later, lowered the underwriting standards for borrower. For all these various reasons, the prizes for real estates experienced started to rise and a bubble started to emerge (Diamond & Rajan, 2009).

2. The Credit Boom

The credit boom was leading to an unmanageable leverage. Due to very low interest rates (only 1%), very cheap credits were available. Bankers encouraged their borrowers to take credits to the “(…) full amount of their property and to borrow more as soon as the value went up, with little regard to their ability to service the debt” (Carmassi, Gros, & Micossi, 2009, p. 980).

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Details

Pages
12
Year
2014
ISBN (eBook)
9783656956334
ISBN (Book)
9783656956341
File size
631 KB
Language
English
Catalog Number
v299134
Institution / College
University of St Andrews – School of Management
Grade
15 (2,0)
Tags
last three stock market crashes boom bust predicted

Author

  • Arthur Ritter (Author)

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Title: The Last Three Stock Market Crashes. Can Boom and Bust Be Predicted?