One of the most fascinating aspects of human behavior, is our tendency to become consumed by the next big thing. And many times, we become so enthralled that our sense of reality and our rational thinking become compromised.
In this lesson, we will discuss seven major financial hysterias that eventually lead to panic and subsequent market crashes. We will learn what led up to these various bubbles, and see if there are any root causes that are similar among them. What can we learn from history so that we can prevent ourselves from getting caught up in future market hysterias? We will do our best to answer this key question.
Tulip Mania of 1637
Many market professionals believe that the current cryptocurrency mania is a bubble that is primed to burst soon. But before there was Bitcoin, Ethereum, and Litecoin there were Tulips.
How much would you pay for a Tulip bulb? Probably not too much I would imagine. But back in the early 17th century in the Netherlands, certain types of tulip bulbs were being sold for the price of a house, if you can believe that.
The Tulip mania was one of the first recorded speculative bubbles in history, and is a classic example of how ordinary investors can lose all sense of reality when they are consumed by mass delusion.
It all started in the late 1500s when a local botanist named Carolus Clusius in the Netherlands began to cultivate tulips at the University of Leiden. During his work at his botanical garden, he started to notice that some of the petal colors of the flower began to change colors and this created unique patterns that were quite interesting in shape.
As a result, other local botanists and aficionados began to show interest in purchasing these multi colored tulips and commenced trading these tulips amongst themselves. As word got out, more and more people were intrigued and eventually Tulip brokerages were formed in an effort to facilitate trade for investors.
The prices for these tulips started to rise to extraordinary levels by the mid 1620’s. In fact, some investors where trading their real estate holdings in exchange for certain highly sought after Tulip bulbs such as the Semper Ausustus. The Semper Augustus tulip bulb resembled a candy cane pattern. By 1637, almost everyone was caught up in the craze and the prices reached astronomical levels. And in just over one month in 1637, the prices rose over 1000% for these flowers.
Later that year, as some individuals and investors began to take profit and sell their tulip holdings, prices started to fall. As prices fell, more people began to sell their stock of tulips. In addition to those who sold for profit, late investors started to get nervous and they too fearing a decline in price of tulips fueled the collapse.
And within a very short span of time, there was widespread panic as people seem to have come to their senses, and started to unload their inventory for whatever prices they could get. It is at this time the Dutch government tried to intervene to mitigate the damages and losses, but it was to no avail as many families lost their entire life’s savings during this collapse.
South Sea Bubble of 1720
The South Sea Bubble involved an international British trading firm that was given exclusive authority to trade with the Spanish colonies in the West Indies and South America as part of an agreement with the British government after the War of the Spanish Succession.
The South Sea Company was organized in 1711 by John Blunt and Robert Harley. During this time, England was involved in the War of the Spanish Succession, and the government was seeking funding for the ongoing war efforts. The South Sea Company agreed that in return for taking on a portion of the governments war debt’s it would be granted exclusive trading rights with the Spanish colonies. This seemed to be a win win scenario for both the British government and the South Sea company. The British government would get the necessary funding for their war efforts, and the South Sea company would be able to reap untold riches from this trading monopoly.
The South Sea company was able to sell shares to the public and in addition to the highly lucrative trading profits, investors would also earn a 6% return on their capital which was to be paid directly by the British government.
In an all-out effort to spark investor interest and attract more and more investors, the South Sea company began to aggressively tout the abundance of gold, silver and other metals that were going to be brought back to the country. In addition, one of the company’s directors, John Blunt, even incorporated a risky program to lend potential investors money to buy shares of the company. As a result of this, investors began to buy shares of the South Sea Company in droves.
During this time, the stock price for the South Sea company was souring. In fact, by the summer of 1720, the share price of the company peaked to over £1000. But the company’s profits were nowhere in line with the public image it had created for itself.
And so eventually as the promises made were not coming to fruition, selling ensured and prices began to drop. This selling was fueled by those investors who borrowed money to purchase shares of the company and were unable to keep up with their monthly installment. These leveraged investors had to sell their shares to fulfill their obligations and as a result the share price in the South Sea Company began to take heavy toll.
Within a span of a few months, the share price for the South Sea company fell by over 85%. Many mom and pop investors and well to do aristocrats lost their savings and fortunes during this crash. One famous South Sea company investor was none other than Sir Isaac Newton, who lost in excess of £20,000 which would be valued at over £ 250 million in today’s monetary terms. He later fittingly said that “ I can calculate the movement of stars, but not the madness of men”.
The Stock Market Crash of 1929
The Stock Market Crash of 1929 was the worst stock market decline in percentage terms wiping away almost 90% of the value of the Dow Jones Index within four years.
The stock market downturn started on October 24, 1929 which is often referred to as Black Thursday. The Dow Jones Average opened at 305.85 and fell sharply from the open. It lost 11 percent intraday on extremely high volume. Major Wall Street banks stepped in to try to bolster the market by buying shares to stabilize prices. This strategy did work temporarily as the Dow only posted a loss of 2% that first day. The next day, Dow posted a positive gain, but the following day closed down again which erased the prior day’s gain.
The following trading day, Black Monday, saw a decline of about 13 % for the Dow, falling to 260.64. And on Black Tuesday, the next day, Dow continued its downward slide, falling another 12 % to 230.07. The share market drop during these two days wiped away 25% of the value of the Dow. As investors began to panic, further selling ensued and a bear market leading to the Great Depression was underway.
Prior to the share market crash of 1929, the economy was in full swing and booming. And with the advent of a concept called “margin”, many people who had never before invested in the stock market became active participants.
Brokerage firms were now financing investment in the stock market with just 15 % or 20% down. Even banks joined in, and used depositors’ funds to buy stocks on margin. All of this frenzy led to share price overvaluations, as more and more investors jumped into the market.
As soon as the stock market plunged it wiped out most if not all of the equity of leveraged investors and forced many to liquidate other assets to meet their obligations. In addition, many banks were bankrupt overnight, as they gambled their depositors’ funds in the market, and many only had 5% or 10% left to pay depositors’ claims. Later, in response to these bank failures, President Roosevelt created the Federal Deposit Insurance Corporation to insure customer deposits.
It would not be until 25 years later, in 1954 that the Dow Jones would reach 383, the previous high prior to the Crash of 1929. The Stock Market Crash of 29 has the distinction of being the worst stock market crash in history.
Black Monday – Stock Market Crash of 1987
The infamous day Monday, October 19, 1987 is known as Black Monday. This is the day when equity markets around the world were shaken by a widespread selling frenzy. The Dow Jones plunged over 500 points, which account for a historic single day drop of 22%. This type of single day Dow Jones crash event had never been seen before, not even during the Great Crash of 1929.
And by the end of the month, most Stock Markets around the world were in disarray. The Australian market was down 41%, the Hong Kong market was down 45%, the United Kingdom market was down 26%, and the worst hit was the New Zealand market which had fell almost 60% from its recent high.
So, what caused the 1987 crash? Though the causes cannot not be known for certain, many professionals have put much of the blame on computerized programs that created large quantities of sell orders in the market, and triggering stop loss levels one after another, which eventually spiraled out of control.
This was a time when computerized trading was in its infancy and its impact on the market were not yet fully stress tested. In addition, during this period, leveraged equity index futures products and portfolio insurance products were also introduced. This combination was ripe for an over-leveraged trading environment and where programmed arbitrage trading strategies started to emerge.
The Federal Reserve chairman at the time, Alan Greenspan, quickly sought to aggressively cut interest rates in an effort to stabilize the economy by adding liquidity to the marketplace. After the crash, exchanges began to institute “circuit breakers”, in an effort to reduce market risk from anomalies. Circuit breakers would result in a halt to trading when the daily price movement in the market has reached a dangerous or excessive level.
Many professional traders, institutions, and everyday investors were devastated by the crash of 87, and some of the old timers today can still recall exactly where they were and what they were doing on Black Monday. It is a day that most who lived it will likely never forget.
Asian Financial Crisis of 1997
The Asian financial crisis began with the collapse of the Thai baht, resulting from the Thai government’s inability to support its currency peg to the US Dollar. The Thai baht became a floating currency and devalued sharply as the country was on the verge of bankruptcy. This crisis spread to other Southeast Asian nations as well including Indonesia, Philippines, Malaysia, and South Korea among others.
As a result, these countries’’ stock indices and currencies slid dramatically. Many of these countries had huge Debt ratios, with some topping 170% of their Gross Domestic Product (GDP). A few countries in the region fared a bit better during the Asian crisis, and were less affected by it. Among them were Japan, Singapore, and Taiwan.
The International Monetary Fund (IMF) was forced to deal with this ongoing crisis, and created a bailout package consisting of over $ 100 billion to help stabilize the region. The IMF did place strict contingencies on these countries requiring them to increase their interest rates, reduce overspending, and raise taxes to increase government revenues. This program was a success and eventually after several years, the troubled countries were able to start recovering from the crisis.
Like many other market crashes before it, the Asian crisis was brought on by asset overvaluations, excessive borrowing, over leverage, and unsustainable growth.
Internet (Dot Com) Bubble of 2000
The Internet Bubble of 2000, also referred to as the Dot Com Bubble occurred not too far in the distant past. And so, it is still fresh in the minds of many traders and investors alike.
Unlike anything else prior to it, the Internet has affected the lives of everyone and has brought change to nearly every industry. This was the Gold Rush of that present time. The new age of the Internet welcomed aspiring entrepreneurs to build and create businesses that would change their generation and many generations to come.
During the mid 1990’s as the Internet was becoming mainstream, it created enormous opportunities for online companies. Both private and institutional money was pouring into online ventures like never before. Countless investors were drawn in to grab their stake within the World Wide Web and carve out a fortune along the way.
As the Dot Com fervor was building up, many investors completely ignored the basic fundamental metrics that they held so dear in the past. No longer were they focusing on corporate cash flow, profit margins, or reasonable P/E ratios; but rather they made huge bets on growth projections that turned out to be unrealistic. In fact, many internet startups were routinely being valued based on 75% or more growth over the coming 5 year period. Of course, some companies such as Amazon and Ebay become hugely successful, but by and far, most other internet startups proved to be a flop.
By the end of first quarter of 2000, investors started to become wary of the exorbitant valuations, and things went downhill from there. Stocks began to fall, particularly in the technology sector, and the Dot Com dreams of many entrepreneurs came to an abrupt end. The NASDAQ, which is a tech heavy composite had risen from the 1000 level in 1995 to over 5000 by year 2000. It was due for a major correction. In fact, the majority of stocks and indices fell sharply until the market finally bottomed in 2002. During this period, the market wiped away over 5 trillion dollars in wealth, destroying the dreams and savings of many investors along the way.
The Dot Com bubble of 2000 is a perfect example of exuberance gone amuck. When our good judgement is taken over by mass hysteria in the market, it can be a dangerous time for us financially.
Housing and Subprime Crisis of 2008
The Housing and Subprime crisis, which led to the Stock Market Crash of 2008, is the most recent major collapse witnessed in the US Stock Market and other Equity Indices abroad.
The story begins back in the 1990’s when the US government started to create programs that would make buying a home more affordable, especially for those with less than perfect or troubled credit. They instituted these programs mainly through Freddie Mac and Fannie Mae, which acted as government backed mortgage lenders. Mortgage originators could sell the mortgages back to Freddie and Fannie, who in turn would hold these mortgages.
As a result, originators began to write more and more mortgage loans, and many of these were of sub-prime quality. Interest only loans become popular, and many borrowers were approved for mortgages they could not afford or would never qualify for in the past. At first, this did not cause any major concerns among lenders, as the housing market was steadily rising year in and year out.
As Main Street mortgage brokers were writing a historic number of new mortgages, Wall Street also got in on the action. They started to create and promote mortgage backed securities (MBS), which is a security comprised of a pool of mortgages . The MBS would pay investors attractive interest rates. And investors perceived this as a “low risk” investment since the securities were back by mortgage loans.
In addition, Wall Street introduced a new type of credit derivative called credit default swaps. Credit Default Swaps were similar to insurance policies. They were designed to protect against a company’s default. But a major flaw with CDS was that they were not regulated, and as such, premium writers were not required to segregate and allocate a reserve, as typical insurance companies are required to do. All of these factors lead to a highly over-leveraged environment that was susceptible to systemic risk .
As the housing market began to show signs of fatigue, a major downturn in the market began to ensue. There was a period of 3 weeks between September and October 2008 wherein the Dow Jones Industrial Average sank more than 3500 points from its recent high. This was a huge stock market drop and accounted for more than a 30% decline in the value of the Dow.
Many would argue that what lead to the Subprime Crisis of 2008 originally started with the best of intentions. Who could have predicted that putting more people in homes could lead to such a tragic end? Isn’t buying a home supposed to be the “American Dream”? At least in this case, it turned out to be more of a nightmare than a dream for many homeowners and investors.
Summary
In this article, we have discussed seven major market bubbles, starting with the Tulip Mania of 1637 to the most recent Subprime Financial Crisis of 2008. Although the times when these various financial crashes occurred are all different, and the events surrounding them are quite unique, there are also many similarities that exist. The most prominent of which is that we as human beings are prone to overreactions and give in to mass psychology even though we pride ourselves in being rational thinkers. And this characteristic flaw in all of us is present within our DNA, and the financial market acts as a medium that bears that footprint.
Can the stock market crash again, and if so can we prevent the next stock market crisis? As for the first question, that would be an unequivocal YES. The stock market can and will crash again. And for the latter part of the question, I don’t believe that we can prevent it as history has shown us that investors tend to have very short memories. And so, unfortunately, we will always have boom and bust cycles.
In essence, the question becomes not “Will the market crash again”, but rather “When is the next stock market crash coming”? So, for the astute trader and investor, it is critical that we learn the important lessons from stock crash history, so that we can take the necessary steps to protect ourselves and mitigate any financial damage caused by the next big financial collapse.