When mainstream market average or indices fall severely in consecutive trading periods, it is said to be a market crash.
However, when the severity of the losses is normal, market participants also refer it to as a correction.
Usually, market corrections are healthy as they keep a check on the over enthusiasm of the asset prices and keep prices under control. When the price of any investment vehicle drops over 20 per cent from its recent highs, technicians call it as a bear phase.
Market participants use technical indicators to predict any market correction. Meanwhile, stock market crashes are highly unpredictable, occur unexpectedly and cause severe damage to the investor’s wealth.
Market Crash – A Financial Disaster
Volatility is omnipresent in markets and prices of individual security/ indices rise and fall concurrently, day in and day out. In the meantime, markets witness turbulence in the near term as well as long term.
In a market crash, the impact is very much wider, and most of the market averages/indices tend to be in the red zone, causing substantial erosion of investor’s wealth. Mostly, market crashes arise from significant dynamics and developments in the real economy.
And, market crashes are a result of such development that happened in the past whose catastrophic effects are realised by the community at a later stage, which in turn, leads to panic and wider sell-offs.
Some other factors that can cause stock market crashes may include any unprecedented period of rising asset prices in the market; unjustified optimism surrounding the ongoing developments; the range of earnings multiples outstripping historical averages, and widespread use of leverage by market participants.
The ramifications of stock market crashed could be far-reaching with impacts ranging from an old age pensioner to a store worker in a retailing outlet. Moreover, the stock market crashes impact societies at large.
It also impacts the business, forcing the companies to shut the shop in the wake of liquidity crises, resulting in a widespread job loss. Likewise, the impacts of stock market crash often hurt broader society and create economic turbulence.
Due to widespread disastrous impacts, it also forces public bodies to undertake effective measures to provide support to the ongoing vulnerabilities at the expense of tax-payer’s money.
Most Recent Market Crash
In 2000, the markets witnessed the crash of the technology bubble/dotcom bubble or internet bubble. It was attributed to the unprecedented growth of internet based companies in the late ‘90s. Consequently, investors started to turn highly optimistic of internet companies and started to pour in the capital of these companies.
The rise of new technologies had all investors go berserk for tech-based companies, and multiples for such stocks expanded over time drastically. This madness for internet companies had ignored the expectations of profitability, irrespective of the fact, the valuations of internet companies skyrocketed, without any expansion in the underlying fundamentals.
Meanwhile, the valuations were extremely inflated, and in the five years to 2000, the NASDAQ expanded from 1000 points to around 5000 points. By October 2000, the NASDAQ was down to around 1100s, and in the process, many internet companies closed, which resulted in the loss of substantial jobs and capital.
In 2008, the global markets witnessed the closing of a global investment bank – Lehman Brothers, in the wake of crises in its subprime mortgage-based derivatives portfolio. In order to resurrect the economy from the realms previous market crash – dotcom bubble, the federal bank in the US had slashed the interest rates that led to massive growth in mortgage books of the banks, which were mostly subprime mortgages.
While in wall street, the bankers had started to sell derivative contracts with the portfolio of subprime mortgages as underlying security. In the meantime, the derivative contracts created by the investment banks were rated as highly creditworthy by the credit assessment agencies.
When subprime mortgage borrowers started to default on the interest payments of subprime loans, the interest on the derivative contracts was defaulted by issuers as the underlying security was running on defaults.
Later, when credit rating agencies started downgrading the derivative contracts with underlying subprime mortgages; it resulted in a heavy sell-off in the markets/stock market crash, and ultimately, a liquidity crunch.
While we have discussed much of bane caused by stock market crashes, let’s discuss some boons of the stock market crash.
Excessive Margin of Safety
Due to widespread sell-off in the markets, most of the asset prices in markets tend to hit extremely lower levels. When asset prices hit lower levels, it’s the best time to screen companies that are undervalued, which in turn, results in a broader value gap.
Amid a broader market sell-off, investors often turn jittery, and even good companies face the wider heat. As a result, the valuations of most of the companies tend to hover below their intrinsic value, and a broader scale of value trades start to appear.
Quality Becomes Cheaper
Stock market crash often results in unjustified pessimism in most of the companies. As a result, even the quality businesses face sell-offs in the market usually. Looking for companies that generate attractive returns on equity, having a comparatively lower debt-to-equity ratio should be preferred.
Some other metrics such as quality management, improving gross margins with sound shareholder management could be considered as well. Most of these metrics reflect quality, and therefore, it is likely that recovery in such businesses would be faster comparatively.
Charging the dividend portfolio
For dividend-focused investors, stock market crashes provide an opportunity to increase allocations to such stocks. In the meantime, a higher percentage of future dividend yield could be captured as the valuations are suppressed amid a stock market crash.
Increasing allocation in high dividend-paying companies would increase the potential dividends as more shares mean more dividends companies. Considering companies that have maintained dividend for a longer period even in the times of recession could be highly favourable for dividend seeking investors.
Most ETFs/Index Funds Appear Attractive
Since market averages/indices are trending lower due to the stock market crash, the index funds and ETFs, which are primarily benchmarked to these indices, are available cheaply amid a stock market crash.
Therefore, investors are provided with an opportunity to somewhat diversify the portfolio by investing insuch funds. Eventually, the stock market would return to normal levels in future, and in turn, the index funds/ETFs would also follow a similar trend. As a result, the chances of racking up larger gains are higher in buying when stock markets are extremely down.
Investing in Growth Stocks
As growth stocks carry the potential to grow in price due to the comparative age of the company and industry, the suppressed valuation in the growth stocks could prove to be bargains. Due to higher chances of price appreciation in growth stocks, the investors might be benefitted by allocating capital in growth stocks.
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