Of market rallies and investor follies... - Views on News from Equitymaster

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Of market rallies and investor follies...

May 5, 2006

Investor irrationality has, more than once in the past, given evidences of how the 'herd mentality' can lead to unfathomable market appreciation without the support of sufficient value in the underlying assets. Such phenomena have led to 'market crashes' that eroded investor wealth and dissuaded market participation for a considerable duration of time. It is an oft-repeated scenario in market rallies that investors tend to follow the 'herd' and value a stock beyond any accurate or rational reflection of its actual worth. This creates a situation wherein, once the correction sets in, the majority of investors try to flee the market at the same time and consequently incur massive losses. Attempting to avoid more losses, investors during a crash, indulge in panic selling, hoping to unload their declining stocks onto other investors. Some of the biggest stock market crashes in history have been the best 'learning lessons' for investor vigilance.

The Tulip Bubble (1634-1637, Holland)
In 1593, tulips were brought from Turkey and introduced to the Dutch. The novelty of the new flower made it widely sought after and therefore, sought a premium price. Soon, prices were rising so fast and so high that people were trading their land, life savings, and anything else for tulip bulb futures. Needless to say, the prices were not an accurate reflection of the value of a tulip bulb. At the peak of the market, a person could trade a single tulip for an entire estate. However, once the correction set in, dealers refused to honor contracts and the government attempted to step in and halt the crash by offering to honor contracts at 10% of the face value.

The South Sea Bubble (1711, United Kingdom)
In the early 1700s, when British investors enjoyed prosperity and had enough liquidity to invest, the South Sea Company had no problem attracting investors to its IPO because of an MoU signed with the government (worth 10 m) for purchasing the 'rights' to trade in the south seas. Stocks in the South Sea Company were traded for 1,000 British pounds (unadjusted for inflation) and then were reduced to nothing by the later half of 1720. In the aftermath of this crash, the British government outlawed the issuing of stock certificates, a law that was not repealed until 1825.

The Florida Real Estate Bubble (1926, Florida)
In 1920, Florida became a popular US real estate destination because of its climate. The supply of housing eventually could not match the demand, causing prices to multiply several times. The land that could be bought for US$ 0.8 m could, within a year, be resold for US$ 4 m (5 times higher), before the prices came crashing back down to pre-boom levels.

The Great Depression (1929)
Despite the Florida real estate crash, after the win in the First World War, US investors continued to be bullish on the stock markets, which led to a bubble. The ensuing correction led to a more than 40% drop in the benchmark indices from the beginning of September 1929 till the end of October 1929. In fact, the markets continued to decline until July 1932 when they bottomed out, down nearly 90% from their 1929 highs.

The crash of 1987 (19th October 1987)
In early 1987, in the wake of the stock market rally, the US stock market regulator, SEC, made aggressive investigations into insider trading. The barrage of SEC investigations rattled investors and by October, they decided to move out of equities and into the more stable bond market. Herd-like panic set in and people started dumping stocks in the dark without knowing what their losses were or whether their orders would execute fast enough to keep up with plummeting prices. The Dow plummeted by as many as 508 points (22.6%) on October 19th and investor wealth to the tune of US$ 500 bn got eroded on a single day. Finally, the Fed chief at the time, Alan Greenspan, had to intervene to help fight off a depression by preventing the insolvency of commercial and investment banks.

The Asian crisis
In the later half of the 19th century, the Japanese economy gained momentum after its long recovery from the war and the atomic bombs. The Japanese economy, coupled with the other emerging Southeast Asian economies, formed an unstoppable economic force. Between 1955 and 1990, land prices in Japan appreciated by 70 times and stocks increased 100 times over. The government sought to halt the inflammatory growth of stocks and real estate by raising interest rates. However, this did not have the desired impact and instead, the subsequent correction led to the Nikkei index plunging by more than 30,000 points.

The dotcom crash (2000 - 2002)
Commercially, the Internet started to catch on in 1995, with an estimated 18 m users worldwide. The rise in usage meant an untapped international market. Soon, the public issues of new dotcom companies started getting oversubscribed several times over on the very first day of bids. This frenzy also perpetuated to the Indian markets and one may recollect Infosys trading at a multiple of over 300 times earnings at its peak during this bubble (FY00). At the end of the crash, the NASDAQ Composite lost 78% of its value.

Lessons to learn...
The above instances are cautionary admonitions for investors to stay out of irrational behaviour. This is not to say that stocks cannot legitimately enjoy a huge leap in value, but this leap should be justified by the prospects of the underlying companies, and not just by a mass of investors following each other. The unreasonable belief in the possibility of getting 'rich' quick is the primary reason people burn their fingers in market crashes. One tends to neglect the fact that there is a direct correlation between high risk and high returns. While the history of market crashes does not in any way foretell anything dire for the future, the best thing an investor can do is keep himself/herself educated, well informed and well practiced in doing research.

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