First an understanding of the stock market as a whole is needed. The stock market closely resembles the game Survivor, where each participant is trying to out-think the other. The fundamental statistics, technical indicators, and charting techniques may all be considered a facade to hide what is really happening.
In the stock market, an investor tries to guess what the average investor mood will be in the future. People are buying and selling an emotional roller coaster. When investors begin to figure out that the entire economy is built, not on assets but an ideal, a crash is about to ensue.
Money is Fiction
Money only has value because the government says it has. It is not backed by gold, silver, or any other asset. What would happen if everyone quit believing in the ideal of paper currency? What if the average person would no longer work for dollar bills but only tangible assets such as food and clothing? A crash would ensue that could not be easily fixed.
The Stock Market is Fiction
Maybe a long time ago there was a direct relationship between a companies' net worth and the capitalization of the stock. Today a company can be worth twice or many hundreds of times what the book value is. Why can two identical companies have such a discrepancy between their stock market trading values? Because the stock market is emotionally driven and emotionally priced.
Unrealistic Growth Models
Our world is based on growth. Growth is not necessarily bad, but unrealistic growth causes chaos. Imagine there is a man called Jose in a room with 10 other people. Jose starts up a hamburger stand.
- On day one he sells one hamburger.
- On day two he sells two hamburgers.
By doubling his revenue he draws the attention of a couple investors in the room. They give him money to buy a proper grill and an apron.
- Day three he sells four hamburgers.
Now another couple of individuals want a cut of the profits and invest with the venture. Remember he is only selling to a maximum of 10 people. Jose hires an assistant and buys higher quality meat. The new investors imagine the revenue will continue to double each and every day based on historical performance.
- Day four he sells eight hamburgers which is double the revenue from the day before.
- Day five continues to sell eight hamburgers again and nears market saturation.
All the investors in the room are bullish. As his revenue flat-lines, the investors become afraid. They gave Jose thousands of dollars each as he was doubling his revenue daily. But now they look to his one assistant and his small propane grill and wonder if this company is overpriced. The first investor pulls his funds. The second begins to panic and accepts far less than his initial outlay of capital. Widespread fear hits as each investor realizes that Jose's operation is only worth about 100 dollars.
Jose is decimated and must sell off all his equipment to pay back the investors. Who was at fault? Was it Jose for his great hamburger making idea? Was it the fault of the food buyers as they should have been eating more? No, the blame must lie with the investors who had unrealistic growth expectations of the business. This led to an overpricing of his shares and the bubble led to a burst.
Stock Market Hamburger Stand
The stock market is similar to this hamburger stand. The market is based on investor emotion. As the market goes up, that is perceived as proof that it works, so more people buy in. Buying mania sets in as grandparents and others who never invested in their life suddenly want a piece of the profit pie. When everyone is fully invested, how can prices be driven up further? Someone from the street yells out that the Emperor is really naked, and the market comes crashing down in a panic.
What This Means For Investing
This doesn't mean someone shouldn't invest. All it means is that they should analyze a stock, not to try and discover what its 'true value' is, but try to see it through the emotional eyes of the average investor. Astute investors should analyze a stock's fundamentals and try to determine how others will perceive it. Technical analysis are excellent tools to analyze waves of mania and despair. Knowing how to identify market trends and trading in harmony with them is vital.
So how does a stock market crash? When investors pull their money as they start to realize that the world is much more precarious than previously thought.
Sources
Selena Maranjian, “The Market Crashed -- Now What?”, The Motley Fool, 25 October 2008.
Ben Wattenberg, “The First Measured Century: Stock Market Crash”, PBS.
 |
