What are the mechanics behind a market crash?

[JJSCOTT2]

Ok this is something I've always wondered. I just don't understand how a bunch of people can simultaneously decide that EVERYTHING is worth NOTHING (practically). I would imagine it has something to do with price/earnings multiples leading to the fact that the actual value of the securities pales in comparison to how much money is invested, but it still seems like sort of a perfect storm type situation to me.

[DcifrThs]

um, what?

if people hold a view that is dependent upon speculation that is irrational (march 2000 tech bubble), and the view is finally looking less and less likely, all it takes is some catalyst (like negative earning reports) to trigger some sales.

the view then becomes far less realistic and other panic and sell their holdings at any price they can get thus pushing prices down further.

happens all the time in history of financial markets.

why do you ask?

Barron

[JJSCOTT2]

Sort of just one of those things I've never fully understood. I understand how what you're saying would work for an individual stock, but it just seems like a large collection of companies simultaneously releasing terrible earnings reports isn't likely. If it was over the course of weeks or something a large downward spiral would make sense to me, but in the case of one day large crashes, I'm just not sure I understand what causes everyone to bail out of everything at the same time.

[DcifrThs]

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Sort of just one of those things I've never fully understood. I understand how what you're saying would work for an individual stock, but it just seems like a large collection of companies simultaneously releasing terrible earnings reports isn't likely. If it was over the course of weeks or something a large downward spiral would make sense to me, but in the case of one day large crashes, I'm just not sure I understand what causes everyone to bail out of everything at the same time.

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panic. the prices of those other companies were bouyied by the hope of crazy earnings in the future. one bad earnings report for one company is enough to pop the bubble...it just needs the pin and the earnings report could be that pin.

in general though, market panic ensues when participants feel their holdings are overvalued and sell.

an example happened in late february when there was a rumor that china was going to increase cap gains tax (or some other tax on stock investments or something) and the CSI300 fell 9% ina day. that reverberated around the world and the S&P & Dow both fell by around 4-5% as well as some other equity indices on the view that as goes china's stock market, so goes the rest of the world's. right or wrong, that panic happened and prices fell significantly.

Barron

[Scorpion Man]

[ QUOTE ]
Ok this is something I've always wondered. I just don't understand how a bunch of people can simultaneously decide that EVERYTHING is worth NOTHING (practically). I would imagine it has something to do with price/earnings multiples leading to the fact that the actual value of the securities pales in comparison to how much money is invested, but it still seems like sort of a perfect storm type situation to me.

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read george soros' Theory of Reflexivity

[Fishhead24]

Take a look right now.........the mechanics are in place.......BIGTIME.

[DcifrThs]

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Ok this is something I've always wondered. I just don't understand how a bunch of people can simultaneously decide that EVERYTHING is worth NOTHING (practically). I would imagine it has something to do with price/earnings multiples leading to the fact that the actual value of the securities pales in comparison to how much money is invested, but it still seems like sort of a perfect storm type situation to me.

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read george soros' Theory of Reflexivity

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just to sum up and test my memory:

IIRC, something that is reflexive, according to soros, feeds back on itself. i think an example he gave was the run up in property prices in japan in the late 80s. property values increased as demand for them soared, which caused even higher valuations and less prudent bank loans to developers. rents were extrapolated at far beyond record levels. the prices of the underlying properties caused bank loans taking that value as given (appraised) which further increased liquidity and thus feeds the ever growing demand.

then, when the bubble bursts, the reverse happens. nobody wants to take up rents that high and people rush in to sell properties at lower and lower valuations. those lower valuations make it harder to meet the loan requirements. defaults occur further pushing down property values and people need to sell even more urgently to meet liquidity needs.

sorry for the long winded summation but i think that is the dynamics of a reflexive process (one which creates distortions through a positive, and then negative feedback loop where the increase in an underlying valuation, leads to higher flows into that thing and thus higher valuations until it breaks & then the reverse occurs)

did i miss something, make an error in logic?

thanks,

Barron

[eastbay]

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Sort of just one of those things I've never fully understood. I understand how what you're saying would work for an individual stock, but it just seems like a large collection of companies simultaneously releasing terrible earnings reports isn't likely.

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You're overestimating the degree to which many people see their stocks as pieces of a company with underlying value. Many see them as the equivalent of beanie babies or any other worthless trinket that only has value because someone might buy them for more than they paid. The psychology should be pretty clear from there.

eastbay

[deluz35]

Excellent summary Barron. The Soros book is "The Alchemy of Finance" (1988) He provides several examples of boom/bust processes. FWIW, Soros predicts a real estate crash in the USA in his last book "The Age of Fallibility: Consequences of the War on Terror" (2006)

If too many investors start taking losses, they will all want to sell at the same time, and the prices collapse suddenly. It is a virtual "run on the banks" when all the depositors want to withdraw their money at once and panic when it isn't there.

This type of panic is a very real threat and must be guarded against very carefully in the coming years, as the central bankers deal with the necessary deflation of the American dollar and the servicing of the $10 trillion dollar federal deficit.

[DesertCat]

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IIRC, something that is reflexive, according to soros, feeds back on itself.


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Another example of this is the crash of 1987. This article is the best I could find to explain it and it's just so-so. Essentially my understanding is that if the market declines, portfolio insurance would involve writing puts against the the S&P 500. The put buyers would sell S&P 500 shares to hedge their exposure, driving the S&P 500 price down further, forcing the automated portfolio insurance systems to write more puts and buyers to sell more shares, etc. driving the market down in an enormous spiral of destruction.