What Exactly is a Market Crash?

“Market crash”. Just the sound of the phrase makes most people shudder. But what exactly is a crash, and why do they occur? The answer lies within human psychology. People love bull markets. Bull markets have the uncanny ability to change the collective attitude of society. In a quickly rising market, even the words of rather prosaic business pundits become a form of entertainment. This is what happened in the tech boom as Fed Chairman, Alan Greenspan, became a worshipped celebrity. Eventually the euphoria changes into downright pessimism as the inevitable market crash occurs. Later on, the cycle repeats itself. In order to fully understand these events, we must learn about behavioral finance.

In financial markets, the “majority is always wrong.” When the investing majority or the crowd is overly bearish, this is the best time to be buying stocks. When the crowd is overly exuberant, this is the time to be selling stocks. The financial markets work in this ironic way because not everyone can win in the market. If it were possible for everyone to win in the markets, this would mean that money is being created from nothing. The creation of money, in this manner, is impossible. Therefore the markets are a zero-sum game. Zero-sum means that for every winner, there is a loser. The winner takes the losers money. Zero-sum games are games where the amount of "winnable goods" is fixed. The Start of a Bull Market

The bottom of the market starts at a time when the stock market is weak and the general population is pessimistic. At this point most investors sell after having endured a long and torturous bear market. This extreme pessimism found at a bottom is always irrational and undeserved. Now the market is undervalued and is a bargain. Savvy investors, the smart money, buy bargain stocks knowing that they will be able to sell them higher in the near future. Smart money buying, called accumulation, causes stocks to rise. The smart money often consists of NYSE specialists, Nasdaq Market Makers, hedge fund traders and corporate insiders. These traders have access to information that the general public does not.

Rising stocks eventually gain the respect of mutual funds, as billions of dollars of capital is introduced into the market place. Mutual fund investment causes the stock market to advance in a powerful manner. Much of the steady large trends are powered by mutual funds and other institutional investors. After the stock market has gained, stocks are now fairly valued and are no longer considered bargains. The smart money is now sitting on a large profit, as well. The average investor is still skeptical, however.

As bull market events unfold, retail investors begin to take interest in stocks. Retail investors, or the unsophisticated little guy, make up the vast majority of investors. This group does not invest for a living. Retail investors often make investment decisions based on what they read in financial magazines, from their brokers and from tips from friends. As the flood of retail capital is invested, the market soars, causing great euphoria. At this point in the cycle, many companies become public, or launch an IPO. Companies go public when investor sentiment is most optimistic so as to gain the highest possible stock price. IPO’s generate even more optimism as unsophisticated investors buy into the fallacious thoughts of instant riches. Now is the time when many small investors become wealthy. In this phase, stocks are doubling and tripling as the media cheers on the advancing bull market.

At this point, the smart money sells, or distributes, the now overvalued stocks to overconfident retail investors. The smart money knows that overvalued stocks are no longer worthy investments, and will soon drop in value. Widespread greed always occurs, in some form, at stock market tops. Sometimes this greed takes form as accounting fraud where companies over inflate their values. Other times companies make unrealistic promises, such as dot com stocks without any earnings. These immoral activities can take place because irrational retail investors will buy a stock simply because it is glamorous. To compound the problems, investors will now start to use margin, or leverage, to further accelerate gains. All caution is thrown to the wind as investors think “the old rules don’t apply”.

The Start of a Bear Market

After mutual funds and retail investors are fully invested, the market is overbought. This means that there is no more cash to fuel the rally. The market can only go in one direction: down. All it takes is just a hint of negative news and the market collapses under its own weight. Investors quickly realize the market is made of smoke and mirrors, as frauds or other abuses come to light.

When panic selling starts, a market will always fall quicker than it had risen. Oftentimes, as everyone heads for the exit at the same time, there isn’t anyone willing to buy the stock. This can be especially disastrous for margin users as they grow deeply indebted to their brokers. Bankruptcy is the usual result for these foolish gamblers. The majority of retail investors don’t sell even as the market is plummeting. This crowd keeps holding on to stocks in hopes that the market will recover. As the market plummets 25%, then 50% the average retail investor foolishly holds on, in complete denial that the bull market is over. Finally retail investors sell every stock they own plummeting the market even further. This mass exodus is called capitulation.

The Cycle Starts Again

It is at this point that stocks are undervalued once again. The smart money is accumulating and stocks rise. The majority of retail investors bought at the top and sold at the very bottom. This is the very essence of the “dumb money”. They are perpetually late into the game. This cycle continues over and over. Only the smart money actually “buys low and sells high”. After trading in this manner, the dumb money will adhere to adages such as, “the stock market is risky”. In reality, however, the stock market is only risky if you trade like the mindless majority!