With the coming elections in May, South Africa (and the world) is holding its breath to see the results. A lot of investors are afraid of what the buildup to the election, as well as the results, will do the South African stock market. Coupled with international concerns about a possible impending stock market crash in America, things are looking pretty gloomy for the financial world. Add to that the fact that Standard Bank, one of the leading banks in South Africa is laying off people… One can understand why people are asking whether there is a coming stock market crash.
But do not be too gloomy. There have been times in the past when everything indicated a stock market crash, yet it never happened. For instance, in the 1990s the Japanese exchange was showing a lot of signs that it might crash. But in the end, it the predicted stock market crash never came. And besides, investors are almost always nervous about investing in a country in the runup to a national election. So before you decide to sell all of your shares, read through this blog post first. In this blog post, we will discuss the various factors that can lead up to a stock market crash,
But remember, we can’t predict the future so whatever we say is not set in stone.
What is a Stock Market Crash?
Briefly, it is when there is double digit decline across a broad spectrum of the shares that trade on a stock market. Normally this kind of decline leads to a lot of people losing out on a lot of money.
How does the buildup to a stock market crash look
There are various factors that can lead to a crash in a stock market.
1. Speculative Bubble
The first one, which we witnessed first hand with the cryptocurrency crash last year, is called a Speculative Bubble. What is this, you might ask?
Speculative bubble forms when an asset or currency is trading at much higher values than that asset is intrinsically worth. It is when more and more people start investing in a certain stock until the price to earnings value of that stock is way higher than it should be. In other words, it is when the selling price for a share is a lot higher than what the company actually makes from that share.
Let’s do an example. Imagine you sell burgers every Friday night and you make R1000 per night. But then you decide to sell your burger stand. If someone was to offer you R10,000 it would be reasonable because they can make that money back in ten weeks. But if someone was to offer you R100,000 it would be too much! That person will only make back his/her money in 100 weeks’ time.
Speculative bubbles work on the principle that a company does well, so people start investing in that company. Let’s go back to the burger stand: You do well, so people start giving you money to make burgers in advance. But you can only make twenty burgers per night! Still, more people keep on giving you money to make burgers. Eventually, you have 200 people giving you money to make them a burger on Friday, but you can only serve 20 of them. Once people start to realise that they are paying you for nothing, they will stop giving you money. And so the word will spread and eventually no-one will give you money in advance anymore. Okay the burger example may be a bit crude, but that is basically what happens.
Let’s do a real-world example. Take Bitcoin. From the beginning of 2013, the sell value for Bitcoin started increasing. More and more people started buying Bitcoin and so the selling price went up and up. In the end, Bitcoin was selling for more than $19,000 per coin! But the price to earnings ratio was
2. Geopolitical Circumstances
Politics plays a massive role in how certain stock markets fare. When things seem to be politically stable in a country, the economy grows because people think that it is worth taking risks to start up new businesses. However, once things start to destabilise in the political sphere, investors quickly start selling their shares. They don’t want unstable politics or civil wars to ruin the companies in which they’ve invested their money. So they convert those shares to cash by selling them. Moreover, if a country is unstable, investors will most likely sell all of their shares that they had in that country. Leading to a collapse in the market.
Politics in other countries can also influence the rise and fall of certain stock. If you invest in a gold mine somewhere in Africa and the area around that mine becomes a war zone, the mine will most likely stop operating. Meaning that you will lose the money that you’ve invested in that mine. Unless of course, you sell the shares that you bought in that mine.
3. The Herd Mentality
The herd mentality or crowd behaviour plays an intrinsic role in any stock market crash. People tend to think and act like a pack. So if investors see that larger investors are starting to sell off their shares in a certain company, they will also start selling. This kind of thinking can easily lead to a snowball effect where everyone that had stock in that certain company starts selling. Which depreciates the value of that stock significantly.
4. A Bear Market
Simply put a bear market is when share prices continue to fall over a period of time. Normally a bear market is marked by a decline in the market of 20% or more from the most recent market high. As a rule, one would not speak of a bear market if a single company’s share sell value goes down significantly. One would only refer to it as a bear market if the fall in share prices affects an entire securities index, like the JSE Top 40, for instance. If a market or index keeps on declining like this, investors normally start pulling out and selling shares. And once that starts to happen the herd mentality can easily kick in, leading to full-blown panic and a market crash.
As you can see, there are a number of factors that determines whether a market will crash or not.
Historical Market Crashes
1. Tulip Mania
Possibly the first ever Speculative Bubble in the history of stock markets. Tulip Mania took place in 1637 when the price for one Tulip bulb shot through the roof. According to some, the
2. Wall Street Crash of 1929
After World War 1, the American industry boomed! All across the country, entrepreneurs were setting up shop and the average Joe on the street was infatuated with the idea of becoming rich through buying shares on the stock market. People were so eager to get on board, that large amounts of the population took out loans in order to buy shares. (hint: Don’t make debt to buy shares). Everyone was buying stock! (hint: Don’t buy an asset just because everyone else is buying that asset). But it could never last. In October 1929 the Dow Jones Industrial Average decreased by 40% in value. This led to nationwide panic and everyone started selling stock.
The 1929 Wall Street Crash led to the Great Depression in America, a terrible economic crisis that cost millions of Americans their jobs and their lifestyles.
3. Global Financial Crisis
In September 2008, the world economy was brought to its knees by a series of events that started in America – the failure of 15 American banks. This was due to providing too much credit all round and people couldn’t afford to pay back their loans. Once these loans started defaulting, banks started closing down. The closure of these US banks led to the closure of a whole lot of European banks and the devaluation of the Icelandic monetary system. The effects of this market crash were far reaching, as it led to a global recession where most international stock markets declined by more than 10%.
So, are we heading for a stock market crash or not?
Globally, the sentiment is quite negative at the moment. And who can blame investors for being negative? Historically, it would seem that a lot of stock market crashes can be attributed to American economics. Moreover, the US government is currently knee deep in debt. It seems that they didn’t learn from the 2008 financial crisis, because debt levels just kept on rising once the world economy
- Japan is nearly
attwelve trillion dollars of debt.
- China has more than nine trillion Dollars of debt.
- The UK has three and a half trillion Dollars of debt.
- France, India and Italy are close to three trillion Dollars in the debt.
- Brazil, Canada and Germany all hover around the three trillion Dollar debt level.
Globally we are looking at roughly 250 Trillion Dollars of debt. According to David Stockman,
Just this week, the European Central Bank announced that their initial 1.7% forecast for the GDP growth of Eurozone countries were wrong. They revised it to only 1.1%, which means that the economy is basically at a standstill. Coupled with negative interest rates in the Eurozone, things are looking bad for European stock markets.
If the proverbial pawpaw hits the fan, will it influence South Africa?
Let’s be honest, the current economic climate in South Africa is not great. With the country’s power utility, Eskom struggling to keep the electricity grid up and running and with a corrupt government, investors are not too optimistic about South Africa right now. Add to that the fact that we had a VAT increase last year, people are gloomy at best. And what do investors do when they can’t invest in South Africa? Well they turn to international markets. But when international markets are predicting an impending major market crash, that option doesn’t seem so lucrative anymore.
So it would seem that we are in a catch 22 at the moment. Do we invest in South Africa and stand the chance of losing our money when the lights go out? Or do we invest in the Dow Jones and lose our money when American debt can’t be justified any longer? It seems like we are running out of options here! But are things really looking so down in South Africa? Let’s take a quick look at what the major indices on the Johannesburg Stock Exchange (JSE) did over the last five years.
The JSE had a good run over the past five years. The JSE All Share Index showed steady growth from a low of around 27,000 points in 2012 to where it is today, at roughly 56,000 points. The question is, will this trend continue? Most financial experts don’t think so….
How should you handle a crash, if it comes to pass…
Do not start selling your stock after you’ve read this article. We do not want to cause market panic, now do we? If the stock market starts declining, don’t start selling. You should have enough money to get by, so just hold on to your securities. If there is a collapse, it should stabilise sometime in the future again.
A 2012 study by the Charles Schwab Company showed that investors that hold on to their securities for 20 years never produce negative results. Now it might not be easy for you to believe this, and who allows one single study to govern the way they invest, right? But the fact of the matter is, as long as people don’t sell off their shares en mass, there won’t be a bursting bubble. Instead, the market might go on a slow and steady decline like it did in Japan back in the 1990s without ever going on to become a full-blown stock market crash. So ride the wave, don’t pull out just because things look bleak.
And one more thing, don’t make loans to buy securities. Use money that you can dispense of.