by Erin Lowry
Riding Out the Panic of a Market Crash
I DON’T HAVE a kitschy story for you to start this chapter. That’s the disadvantage of writing a book about investing at the tender age of twenty-nine, with only seven years of investing experience. I haven’t truly experienced a market crash. Sure, I was alive when the dot-com bubble burst, and I certainly experienced the fallout from the Great Recession, but I wasn’t an investor (unless you include amassing impressive Beanie Baby and Pokémon card collections in the late 1990s that grossed negative returns).
Sure, I’ve weathered a few market corrections since jumping into the fray back in 2012, but honestly, I experienced a really significant bull market for most of my early investing years. The only thing I can tell you is “Winter is coming”—it’s still relevant to throw in that reference, right?
A market crash is going to happen during our tenures as investors. At the very least, a bubble will burst or a significant market correction will occur. Whatever we call it, we’re likely to face a real crash of some sort. Maybe once, maybe several times. As they say, “What’s past is prologue.”
There is no way to predict how the stock market will perform during the course of our journey as investors. However, understanding the past may help us ride out the panic of a market correction or even a crash. Okay, that might sound strange to you. Why would reading a horror story make you feel encouraged to invest? Well, because of what happens after: the market recovers. Learning the history of bubbles and crashes helps reinforce the idea that the stock market is indeed cyclical.
A HELPFUL HISTORY LESSON
There are four significant market crashes and two bubbles that rookie investors should know about before getting into the game. Keep in mind, these summaries are significantly simplified versions of what happened because frankly, each crash or bubble could be its own book.
First, You Need a Basic Understanding of What an Index Is
Have you ever watched CNBC, Fox Business, or any business news–specific channel and heard an anchor say something like “The Dow was up 190 points at closing”? Or maybe your parents had the TV on and you just happened to hear such a phrase as white noise in the background. The “Dow Jones Industrial Average,” the “S&P 500,” the “Nasdaq,” “Russell 3000,” and many more are all major stock indices.
You may remember my mention of an index when we discussed index funds. An index is a grouping of stocks (or bonds) that is used as a benchmark for market performance. Each index tracks a different grouping of companies. The Dow Jones Industrial Average (DJIA) benchmarks thirty of the most influential companies in the United States. Founded in 1896, it is one of the oldest indices in the world, so naturally, the thirty companies* change over time. There is bound to be overlap among indices. For example, Apple is on the DJIA and also on the S&P 500 index.
The S&P 500 index is another one of the most frequently referenced indices. As the name implies, it tracks five hundred large-cap* US companies from a variety of sectors. The S&P 500 is often used as a benchmark for how the overall stock market is doing.
You will hear references to indices throughout this chapter and your entire investing life. “It’s relevant to understand what an index is,” says Jill Schlesinger, CFP®, CBS News business analyst and author of The Dumb Things Smart People Do with Their Money. “The reason why it becomes important is to understand what you’re comparing yourself against. So, do I think it’s important to understand the difference between how the Dow is calculated versus the way the S&P 500 is calculated? Not really. What’s important to know is that there are different indexes, and the reason we talk about them is to give us a means to compare ourselves against a specific index.”
Another important term to understand throughout this chapter is recession. It refers to a period of stagnant or even declining economic growth. Some of the indicators used to determine if the country is in a recession include unemployment, industrial production, trade, and oil consumption.
Okay, with that tidbit out of the way, let’s go back in time to examine some peaks and valleys in the stock market.
Tulip Mania
This isn’t a stock market crash, but one of the most commonly discussed examples of a bubble. Bubbles, as described in chapter 2, follow a simple pattern: a commodity becomes popular; people go crazy trying to buy it, thinking someone else will pay even more; the price of said commodity hits a peak; people start selling; panic sets in; and the whole market around the commodity plummets.
What Happened
Hundreds of years ago, the Dutch got so crazy for tulip bulbs that it created a scarcity, and thus supply and demand drove the price of tulip bulbs up and up. Folks dumped their life savings and traded land to stockpile bulbs. Ultimately, as with all bubbles, it burst in 1637. People started to sell the stockpiled bulbs in order to actually cash in on their investments, which led to more and more people selling, which made prices plummet, which only made more people panic and try to sell, which triggered a crash.
Black Tuesday, October 29, 1929
What Happened
The stock market crash of October 1929 precipitated the Great Depression. After a bull market during the 1920s, many stocks were overvalued due to speculation. But the American economy was already showing signs of a decline. Unemployment had risen, wages were low, large bank loans couldn’t be liquidated, and steel production was declining.
The stock prices started to fall in September through early October, which triggered panic from investors. Some historians point to the Hatry Crisis as a contributing factor. Clarence Charles Hatry issued fake securities to investors, a fraud that panicked the UK markets and then impacted the US markets because investors pulled money out to settle the losses they’d experienced from Hatry. The fraud spooked investors, making some wary of continuing to put money into the market. It didn’t help that the newspapers of the day were running inflammatory headlines about the widespread panic.
The crash began on October 24, 1929. The final day of the crash, October 29, 1929, is known now as Black Tuesday. Fourteen billion dollars1 were lost on that day alone, with the entire four days seeing losses of $30 billion. That’s more than $400 billion in 2018 dollars. By 1932, investments were worth only 20 percent of what they’d been worth pre-crash in 1929.
During this market crash, there were also runs on banks, which you may remember if you’ve ever seen the movie It’s a Wonderful Life. Panicked Americans ran to their local bank in an effort to take out their life savings for safekeeping at home. The banks didn’t have enough money in the vaults to satisfy the demand, and many closed. Some would reopen and offer customers a fraction of what they’d actually saved, but others shuttered entirely,2 which naturally caused more panic.
The runs on the bank sparked the creation of the Federal Deposit Insurance Corporation (FDIC). Your FDIC-insured bank today now provides protection of up to $250,000 in cash, as of 2018. If anything were to happen to your bank, you’d get your money back up to $250,000, which is a move to protect the public’s confidence in the banking system.
Recovery
The market’s recovery depends on how you evaluate the data. Generally, you’ll read that it took a whopping twenty-five years for the markets to completely bounce back to pre-crash levels. Bear in mind, the United States did fight World War II during that time period as well.
However, other stock market analysts would argue that it took much less time for the market to actually recover. For one, the twenty-five-year argument doesn’t account for the fact that, during the Great Depression, the country was in a period of deflation, and it depends on if you’re segmenting the market by indices or looking at the stock market as a whole. Those who make this argument contend the average investor who put a lump sum into an average stock in 1929 right before the crash would’ve actually ended up breaking even by 1936,3 assuming they didn’t sell their investments when the market crashed.
Black Monday, October 19, 1
987
What Happened
Well, clearly we aren’t ones for clever new nicknames when dubbing stock market panics. Black Monday occurred nearly sixty years after Black Tuesday. On Monday, October 19, 1987 (Sunday in the United States, as the markets were opening in Asia), a crash started in Hong Kong and spread through the European markets before hitting the United States. This crash showed just how interconnected the global markets had become. However, we can’t point fingers at the Asian markets and say it was completely triggered there. Indicators had started to crop up in the United States that a market correction was coming.
The market had been on a bull run that year, with the Dow Jones Industrial Average (DJIA) up 44 percent in a matter of seven months, reaching a high of 2,722 points in August. That fact alone set off some alarm bells that a market correction could be on the horizon. Then the federal government announced a trade deficit that was higher than expected, which caused the dollar to lose value. The creation of portfolio insurance fostered a false sense of security, and forced selling to protect portfolios once the crash started. Plus, computer technology in the form of program trading to place large-scale buy or sell orders was relatively new to the market and served as a bit of a scapegoat after the crash.
On Friday, October 16, the DJIA dropped 108.35 points.4 It was the first time in history the Dow had ever lost 100 points in one day and was the most significant drop since the Great Depression. For today’s context, 100 points is no longer considered a significant drop because of how high the DJIA has climbed since the 1980s. For example, the Dow lost more than 1,000 points in a market correction in early 2018 that didn’t create widespread panic.
Then, on Monday, October 19, after investors saw what had happened in the Asian and European markets, people started to sell. The Dow opened at 2,246.73 and then plummeted as soon as the opening bell rang. It dropped 508.32 points, to 1,738.41, by day’s end, a 22.6 percent loss, making the previous Friday’s historic drop look like chump change.
Recovery
The recovery process started almost immediately. The Dow actually bounced back 300 points within just two days and had returned to pre-crash highs in two years.
Dot-com Bubble and Crash of 2000–2002
What Happened
The dot-com bubble burst when I was only in the fifth grade, but it’s such a touchstone for modern investing that I still know some of the cracks made about companies like Pets.com, and I actually remember using Ask Jeeves. For you younger Millennials and Gen Zers, that was Google before Google. Jeeves was a butler on the website to whom you directed your burning questions. We could be still saying “Ask Jeeves” instead of “Google it” or “Ask Siri/Alexa” today if things went differently.
The late 1990s saw a huge uptick in tech-related IPOs (initial public offerings). The internet was still in its early years and the potential for a “new economy” led to wild speculation. As with all bubbles, tech companies were overvalued and given millions in funding from investors all hoping to find the next big thing.
Pets.com still serves as a cautionary tale: it went from an IPO to being liquidated as a company in less than a year. The day of the IPO, in February 2000, Pets.com stock sold for $11 a share, and by November 2000, the share price had dropped to $0.19.
While other crashes featured the Dow Jones Industrial Average as the benchmark measuring the stock market’s performance, this crash focuses on the Nasdaq Composite Index. Nasdaq started in 1971 as the world’s first electronic stock exchange, so it should be no surprise that a lot of tech companies choose to go public on the Nasdaq stock exchange. While not exclusively a technology-focused index, it heavily leans toward tech companies. For that reason, the Nasdaq is often used as the barometer instead of the Dow Jones when discussing the dot-com bubble.
The Nasdaq exploded with growth in the late 1990s, with all the tech company IPOs moving from around 1,000 points in 1995 to more than 5,000 in 2000. The peak of the bubble occurred when the Nasdaq reached an all-time high of 5,046.86 on March 10, 2000. On March 11, 2000, the bubble burst, and the Nasdaq started to drop. By the fall of 2002, it had dropped as low as a little over 1,100 points.5 Its previous high wasn’t surpassed until almost exactly fifteen years later, in April 2015.
The tech bubble bursting wasn’t the only event to drastically impact the stock market and the recession of the early 2000s. The 9/11 terrorist attacks also sent shock waves around the global markets. The New York Stock Exchange and Nasdaq closed for four days following the attacks, to prevent panic selling by investors. When trading resumed, the market experienced a 7.1 percent decline in one day. The Dow Jones was down 14 percent overall by the end of the week, with the S&P 500 down 11.6 percent.
Recovery
The Nasdaq, Dow Jones, and S&P 500 all returned to pre-9/11 prices within one month of the attacks, but the market did dip again in the latter half of 2002. By 2003, the market appeared to be back on an upward trajectory—an upward trajectory that would fumble just five years later.
The Great Recession, 2007–2009
What Happened
The Great Recession is the market crash often cited as the reason Millennials don’t get into the investing game. We came of age during the crisis and not only saw but experienced the fallout firsthand when we attempted to enter the job market.
The subprime mortgage crisis typically takes the heat as the culprit for the Great Recession. Home buyers were approved for mortgages for which they weren’t qualified, because of either poor credit or low income. These subprime loans were often positioned to buyers as cheap at first, and then would bloat with higher interest rates and monthly payments after the first couple of years.
The buyers would sometimes be sold on the message that within two years they could clean up their credit and just refinance the subprime mortgage to get a better deal and avoid the inflated interest rate. Obviously, that’s not what happened, and people soon were faced with horribly high monthly payments that made no dent in the actual principal of their mortgage balance, even after a few years of payments. This was also exacerbated by the fact that some people took out mortgages without any money down, so the entire home was financed with a loan.
The banks knew these loans were high risk. Sometimes these mortgages were bundled together as “mortgage-backed securities” and sold as investments to financial institutions, where they could end up in pension funds and mutual funds.
Everything started to go sideways when the Federal Home Loan Mortgage Corporation (Freddie Mac) announced that it would no longer purchase subprime mortgages or mortgage-backed securities. Within a few months, New Century Financial Corporation and American Home Mortgage Investment Corporation declared bankruptcy. Investments that were backed by subprime mortgages were now viewed as risky, and housing prices began to fall across the country. This is what started to impact the everyday American. As house prices fell, people suddenly went “upside down” on their mortgages, which meant they owed more than the house was now worth.
The next hit came as the stock market began to decline. The Dow alone went from more than 14,000 points to 6,547 in only one and a half years. That resulted in a huge blow to retirement plans, pensions, and the portfolios of average Americans.
As this was all happening, investment banks that were bullish on their investments in subprime mortgages began to collapse. First was Bear Stearns, in March 2008, followed by Lehman Brothers declaring bankruptcy that September. The federal government stepped in, offering relief (financed by the taxpayer) to struggling financial institutions, banks, and even some automakers. You may remember that the expression “too big to fail” became quite popular at this time.
Recovery
The summer of 2009 is often cited as the end of the Great Recession because the stock market began to rebound and unemployment rates began to go down. The government created the Dodd-Frank Wall Street Reform and Consumer Protection Act in the aftermath
of the Great Recession to more strictly regulate the financial industry, but as political factions change in the White House, so, too, do regulations on financial institutions.
While 2009 marked the end of the Great Recession on paper, the fallout for the average American was far from over. It took far longer for the job market to heat back up, and many Americans were dealing with foreclosed homes, trashed credit scores, and decimated investment portfolios.
The stock market, however, went on a bull run. Investors who stayed the course during the Great Recession were well rewarded in the decade following the crash. The Dow had dropped to 6,547 points in 2009, but it soared to new, prerecession highs by 2018, when it closed at more than 26,000 points. The S&P 500 index quadrupled during the bull run, from its low of 676 points in March 2009 to as high as 2,872 points in January 2018.6
PLAYBOOK FOR HANDLING A DOWNTURN
It’s stressful to watch your net worth suddenly drop by hundreds or thousands or much, much more in just a day. Unfortunately, that’s what happens when the market tumbles, crashes, plummets, drops, takes a bath, dips, or whichever other term you prefer. Your primary job is to leave well enough alone. But that can be hard, so here are some tips on how to handle the anxiety in the pit of your stomach.
First, Know It’s Coming—Eventually
I’ve said it many times already in this book, and I’m going to keep pushing this point because it’s important. The market will go down.