Nobody Likes a Stock Market Crash, but This is Why We Need One


Editor’s Note: Port Phillip Publishing is taking a short break for the holidays. We will be returning to our posts on 4 January, 2016. While our editors enjoy a few days off with friends and family, we thought you may enjoy reading some of their vintage pieces from 2015. You’ll see the date that these articles were originally published up top. Facts and figures have not been updated. Happy holidays.

The following article was first published in Money Morning on 24 September 2015.

Nobody Likes a Stock Market Crash, but This is Why We Need One

Yesterday, the Aussie S&P/ASX 200 index fell 105 points.

The index closed below 5,000 points.

That’s significant. It’s the first time since July 2013 that the index has closed below that level.

And what’s more, it means the Australian share market is nearly 1,000 points below (984 points, to be precise) the recent high reached on 27 April this year.

Call it what you like — a correction, a dip, or a pull-back. But we’ve only got one word for it. It’s simple. It’s a stock market crash.

We often hear folks, mostly in the mainstream, who say they’re pleased when the market has a ‘pull-back’ or a ‘dip’.

They always say the same thing. They say it gives them the chance to buy more stocks, but at a cheaper price.

In fairness, we can’t really disagree with their logic. If they think stocks always go up long term, then a ‘pull-back’ or a ‘dip’ is a good opportunity to buy more stocks on the cheap.

But what if stocks don’t always go up? Or what if stocks are in the process of heading much lower…crashing even?

Well, that’s a whole different story.

Crashes can take longer than most people think

Most people are surprised by how long it can take for a crash to develop.

They seem to have this view that a crash involves the stock market reaching a new high and then suddenly plummeting 20% or more on that day.

But that’s not how it happens.

Even the fabled crashes of 1929 and 1987 took weeks to play out. In 1929, the Dow Jones Industrial Average peaked on 3 September. But the precipitous crash didn’t start until weeks later.

In fact, the biggest daily moves didn’t come until the end of October that year.

It was a similar story in 1987. The Dow peaked on 25 August. But the ‘Black Monday’ collapse didn’t happen for another two months, on 19 October.

That’s when the index closed down 22% from the previous trading day.

As for the 2008 crash, remember that the Dow hit the high point in October 2007. But it wasn’t until September and October 2008 that the biggest losses came. And then it took until March of 2009 for the Dow to actually bottom out.

Source: Bloomberg

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So, as great as it would be to think that stocks have already ‘crashed’ or ‘corrected’, don’t get too excited just yet.

The truth is that stock market crashes are typically much more painful than most people think.

We remember the 2007 to 2008 period clearly.

As the market ground lower after the 2007 high, commentators, analysts, and financial advisors were quick to tell people that it was a ‘pull-back’ that the market needed.

But, they said, don’t worry, because once this pull-back ends, stocks will race higher.

Except they didn’t. Rallies came and went, but the market continued to fall. Until finally, in September and October 2008, stocks crashed. You can see that on the chart above.

And here’s the thing: there’s no guarantee that won’t play out again. In fact, after nearly seven years of central bank money printing and near-zero interest rates in the US and Europe, a stock market crash is not only likely…it’s necessary.

Here’s why.

A well-timed stock market crash warning

Both here in Australia, and overseas, debt levels have soared over the past seven years. That’s during a time when the mainstream said the world was deleveraging.

Remember that the McKinsey & Co study revealed that between the fourth quarter of 2007 and the second quarter of 2014, world debt levels had increased by US$57 trillion.

We’ve gone into detail in the past about why that has happened. But in short, low interest rates have enabled good companies and bad companies both to increase their debt levels.

A company that would otherwise go bust if it had to pay a double-digit interest rate, can muddle by perhaps for years if they can secure debt at 4% or 5%.

You may think that sounds like a good thing. After all, isn’t it better to give companies the best chance of success?

On the surface, that’s fair. The problem comes when you look at it from the investor’s point of view. Low interest rates can disguise the real viability of a business.

Investors may think that a business is in good shape, without realising that it’s only cheap debt that’s keeping the company from going broke.

If interest rates rise, those companies (‘zombie’ companies as some people call them) can no longer meet their obligations. They can’t grow revenue and profits because, remember, it’s a bad business.

But that’s the sort of thing a booming market and low interest rates hide. Investors only notice or realise the error in their thinking once the market begins to fall…and especially once interest rates start to rise.

That’s why we have warned about the impact of rising interest rates in the junk bond market. Rising junk bond yields are an early warning sign that investors are starting to get cautious. Worryingly, junk bond rates continue to rise.

But all up, while we may not be happy to see stocks crash, we can’t deny that it’s inevitable and necessary. The market needs to weed the bad investments from the market. A crash is necessary to punish companies, investors, creditors, and debtors for their bad decisions and excessive risk taking.

It’s why, unlike most in the mainstream, we’ve tried to help investors prepare for this crash. We’ve told them not to put all their money in stocks. In fact, we’ve even told investors to hedge their stock portfolios in preparation for a crash.

We know that many folks didn’t appreciate that advice at the time. We took a lot of flak for even issuing the warning. But, seven weeks after giving the warning, the Aussie market is over 12% lower, and like it or not, odds are it could yet fall even further.



PS: You can find out more on our 4 August ‘crash warning’ call here.

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Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Daily Reckoning e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.

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