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Stock Market Melt Down; Part II
Sam Pearson 5/12/2021 5:35 AM

Stock Market Melt Down; Part II

Last week we discussed how a melt up in the stock market is soon followed by a Melt Down in stock prices. There are many ways that a meltdown is defined—some prefer to call it a crash. If one analyzes a meltdown or crash, he may see it as a stock market or a stock market index losing more than 10% of its value in a single day. Most market managers would describe the meltdown in a more general view, simply stating that a crash is a significant or dramatic loss in the stock market's value, and the prices of shares overall, usually within a short period of time. At any rate, one would likely say that a stock market meltdown/crash occurs when confidence in the value placed in publicly traded assets goes down. This causes investors to: 1) sell their positions, 2) move away from active investing, and 3) move their funds into cash or an equivalent product.

As we saw in last week’s discussion, the impact of a stock meltdown can vary as well. Sometimes, it's limited. For example, on Oct. 19, 1987, after five years in a strong bull market, the Dow Jones Industrial Average and S&P 500 both dropped over 20%. This was after markets throughout Asia and across Europe melted down by up to 45% (Hong Kong). The crash was short, and markets quickly recovered. Within a few days, the DJIA regained more than 43% of the points it lost and within nearly two years the market had recovered almost 100%.[1]

Not all meltdowns are short-lived, as government intervention can significantly lengthen the time it takes to recover from a stock meltdown. The most notorious example is the Crash of 1929. Stock prices dropped first on October 24, briefly rallied, and then went into freefall on October 28-29. Ultimately, the market lost 85% of its value. Though not the sole cause, however, President Roosevelt’s socialist policies was one of the contributing factors of the Great Depression lasting nearly 10 years.[2]

The obvious question is how one knows if a meltdown is imminent and when to go to a cash position within one’s portfolio. Let’s review five of the most obvious signs that a meltdown is imminent. The first is a rapid rise in stock prices, as we have seen numerous stock market bubbles including the real estate bubble as well as the tech bubble formed after the rapid increase of prices of the stock. The problem with bubbles is that they give rise to panic-selling.

The second is borrowing to build market share (Margin Debt). This is currently what we see in Biden Administration as they create debt (soon to be $9 Trillion). These investors want to make more money in a short time, or give the perception of a growing economy in a governments case; thus, they borrow to invest. More often than not, these are the short term investors who see a huge rise in the stock market.

The third sign is an increase in Initial public offering (IPO) or stock market launch, a type of public offering in the stock exchange where shares of a company are sold to institutional investors and retail investors. 

The fourth sign is mergers and acquisitions. Companies typically grow in two ways—customer acquisition or mergers and acquisitions of companies. With the access of cheap debt at a close to zero interest rate, companies often choose to expand their business by the means of mergers and acquisitions of their competitors. By depleting their cash reserves, companies are vulnerable. Companies can fail and end up in bankruptcy, from failed mergers and acquisitions. Increase of debt interest rate may also cause the company to fail. As the company is unable to meet its debt obligations due to the lack in cash flow, these companies are forced to close down.

The fifth sign is Issue Debt. When major multinational companies like Facebook, Apple, Netflix or Google and other corporations issue debts for major stock buybacks. This can be a potential trigger of a stock market crash. A stock buyback scheme is great for the shareholder, but when debt is required to be issued to perform a major stock buyback, things can get nasty in a hurry, and the collapse of one major company can crash the market. One may recall that the collapse of one such company was the trigger of a market crash. Though not through the reasons of issue debts for major stock buybacks, the fall of Lehman Brothers was the trigger of the financial crisis of 2007-08.

Next week we will be discussing Simple Moving averages and how they help us to first define the market trend and second, to recognize changes in the trend. That's it. There is nothing else that they are good for. However, based on the trend we can establish exit and re-entry strategies for the stock market as it begins to melt down and then again when it begins once again to trend upward. I won't be getting into the gory details about how they are constructed. There are plenty of websites and books that will explain the math. 

May you have a blessed and successful week!






[1] Sornette, D. (2017). Why stock markets crash: Critical events in complex financial systems. Princeton University Press.

[2] Root, D.W. (2004). Bad deal: How FDR made life worse for African Americans. Reason Foundation.

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Sam Pearson
Sam Pearson is a retired Army Colonel with a variety of experience in both government and private sectors. As arguably one of the World's foremost military logisticians, he has been responsible for the on time delivery of supplies and services worth billions of dollars. After service in Southwest Asia, he was hand picked to support logistics operations in support of earthquake relief operations in Haiti. Pearson now serves as a consultant and volunteer mentor for students seeking their doctorates in advance statistical analysis.

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