Stock Market bubbles and crashes

What causes the stock market to drop sharply

The Different Stages of a Stock Market Bubble

VALUE INVESTING

*Stock Market bubbles and crashes

A stock market bubble, also known as an asset bubble or speculative bubble, occurs when the price of a stock or
asset rises exponentially over time, much above its intrinsic value.

As the bubble “pops,” prices eventually hit a ceiling and then plummet dramatically.

Aside from equities, bubbles can arise in a variety of assets, including real estate, commodities trading, and
cryptocurrency trading.

Pure speculation fuels a stock market bubble. When the price of an asset begins to rise at a rate that exceeds its
fundamental value, a bubble begins to form. Then investors are willing to pay increasingly higher prices for a
security or other asset, above and above what is projected based on factors such as demand, earnings, revenue,
or growth potential.

It's important to remember that not all price accelerations are bubbles. It's common for asset prices to rise
sharply after a recession or bear market, for example.

While hope and speculation may also fuel the rebound—the essential difference is that these price gains can be
justified by fundamentals in the end.

What causes the stock market to drop sharply:

1. Speculation:Many market crashes can be blamed on speculation. The Crash of 1929 was a speculative bubble
in stocks in general. The crash in tech stocks in the early 2000s followed a period of irrational speculation in dot-
com companies. And the crash of 2008 can be attributed to investor speculation in real estate.

2. Excessive leverage:For example, if I buy Rs. 5,000 worth of stock and it rises by 20%, I made Rs. 1,000. If I
borrow an additional Rs. 5,000 and bought Rs. 10,000 worth of the same stock, I would make Rs. 2,000, doubling
my profits.

On the other hand, when things move against you, leverage can be downright dangerous. Let's say that my same
Rs. 5,000 stock investment dropped by 50%. It would sting, but I would still have Rs. 2,500. If I had borrowed an
additional Rs. 5,000, a 50% drop would wipe me out completely.

Excessive leverage can create a downward spiral in stocks when things turn sour. As prices drop, firms and
investors with lots of leverage are forced to sell, which in turn drives prices down even further.

What causes the stock market to drop sharply:

3. Interest rates and inflation:Rising interest rates are a negative catalyst for stocks and the economy in general.

higher interest rates mean higher borrowing costs, which tends to slow down purchasing activity, which can in
turn cause stocks to dive.

4. Political risks:Markets like stability, and wars and political risk represent the exact opposite. For instance, the
Dow Jones Industrial Average dropped by more than 7% during the first trading session following the Sept. 11,
2001, terror attacks, as the uncertainty surrounding the attacks and the next moves spooked investors.

5. Tax changesThe Tax Cuts should certainly have the effect of higher corporate earnings, and is likely to be a
generally positive catalyst for the market.

On the other hand, tax increases can have the opposite effect. 6. Panic”

It's important to point out that crashes are typically a combination of a negative catalyst and investor panic that
causes a sharp dive in the stock market.

For example, the steepest market drop during the financial crisis occurred during September and October 2008.
Yes, it was real estate speculation and excessive leverage that led to the trouble, but fears that the U.S. banking
system could potentially collapse sent investors into a panic, which led to the actual crash.

Q1.The Different Stages of a Stock Market Bubble

*Displacement:

A large event, or a series of adjustments, influences how investors think about markets in early stages of bubble.

Boom:

Price increases during the displacement stage, but things really get up during the second stage of a bubble. As
word of the asset's gains spreads, the boom period attracts speculators, who assist drive the price of the asset
higher.

*Enthusiasm:As the asset's price soars, People are more motivated by excitement than sensible justification for
the massive price increase. And, because fresh investors are eager to join, there's a feeling that someone will
always be willing to pay more for the asset.

This can make it seem as if there's no way you'll lose money regardless of when you invest.

*Taking a ProfitBooms are followed by collapses, and as the bubble enters the profit-taking stage, some investors
begin selling to lock in gains. The stock market bubble has burst, and those who understand the warning signs
will profit sooner rather than later.

*PanicWhen prices started declining, some late-comers to the game may have waited out in the past, hoping
that an asset's price would rise again, will start selling by the time the bubble reaches its panic stage.
The dotcom bubble was a rapid rise in U.S. technology stock equity valuations fueled by investments in Internet-
based companies in the late 1990s.

The value of equity markets grew exponentially during the dotcom bubble, with the Nasdaq rising from under
1,000 to more than 5,000 between 1995 and 2000.

Equities entered a bear market after the bubble burst in 2001.

The Nasdaq, which rose five-fold between 1995 and 2000, saw an almost 77% drop, resulting in a loss of billions
of dollars.

The bubble also caused several Internet companies to go bust.

The dotcom bubble

Reason of dotcom bubble burst:

The dotcom crash was triggered by the rise and fall of technology stocks. The growth of the Internet created a
buzz among investors, who were quick to pour money into startup companies. These companies were able to
raise enough money to go public without a business plan, product, or track record of profits.

The dotcom bubble burst when capital began to dry up. In the years preceding the bubble, record low interest
rates, the adoption of the Internet, and interest in technology companies allowed capital to flow freely,
especially to startup companies that had no track record of success. Valuations rose and money eventually dried
up. This led companies, many of which didn't even have a business plan or product, to collapse, causing the
market to crash.

The 2007-2009 financial crisis developed gradually. Home prices began to fall in early 2006.

In early 2007, subprime lenders began to file for bankruptcy.

In June 2007, big hedge funds failed, weighed down by investments in subprime loans.

In August 2007, losses from subprime loan investments caused a panic that froze the global lending system.

In September 2007, Lehman Brothers collapsed in the biggest U.S. bankruptcy ever.
When the bubble burst, financial institutions were left holding trillions of dollars worth of near-worthless
investments in subprime mortgages.

The Great Recession that followed cost many their jobs, their savings, and their homes.

2008 Financial Crisis:

The 2008 financial crisis began with cheap credit and lending standards that fueled a housing bubble.

Black Monday: 2020 Stock Market Crash:

The Coronavirus pandemic had an effect on all sectors. Earlier in March 2020, fears of recession sent stock
indices lower.

While global markets got highly volatile beginning March, it is the stock market crash in 2020 on March 9 that
will be remembered as the Black Monday. When global stock indices, crashed to their lowest in a single day. This
movement has been recorded as the most severe since the global recession in 2008. These indices continued to
record further historical losses on March 12 and March 16.

India felt these ripple effects too, and in March the BSE Sensex plunged to close over 2,919 points, (or 8.18
percent), triggering a circuit breaker immediately after market opening. Intraday records show that the index
crashed as much as 3204 points, its biggest one-day drop. The NSE Nifty suffered an equal decline of 8.30
percent in a day.

Causes of Stock Crash 2020

Uncertainty about how the coronavirus pandemic would set off a possible recession, layoffs, global economic
slump, coupled with compression in oil prices due to the on-going oil price war between Russia and Saudi Arab,
triggered the market reaction that we witnessed post March 12.

Coronavirus Pandemic:

The World Health Organisation declared coronavirus outbreak as a pandemic that set off a series of global
lockdowns and travel bans as Covid-19 infections and infection-related casualties leaped across the world going
into lakhs. Investors worried about the repercussions of the pandemic on markets and economy, started pulling
their money out en masse, which led to stocks crashing in global markets. The pandemic not only brought global
trade to a standstill, but domestic production has also come to a screeching halt in many countries grappling
with the scope of the virus.
Neurofinance:

Behavioral finance studies describe market price anomalies and individual decision biases.

Neurofinance research illuminates the fundamental mechanisms that underlie how individual biases, irrational
behavior, and collective buying and selling decisions emerge.

Using research tools and techniques borrowed from the field of neuroscience, scientists are gaining the
necessary insights to build comprehensive economic models of human economic behavior and decision-making.

Just as the field of economics provides a foundation for traditional finance, neuroeconomics research is
informative of neurofinance.

Neurofinance is not a separate field so much as a set of experimental techniques and tools that practitioners in
many other fields adopt to investigate questions of central interest.

Neurofinance experimentation is defined by the use of the scientific method to identify drivers and modifiers of
choice behavior.

Neuroeconomics has recently emerged as a new interdisciplinary scientific area aimed at examining the role of
the brain that, as a organ, influences, automatically and unconsciously, individual behaviour in financial
decisions.

Neurofinance investigates the brain's activity in financial decision-making processes. The most salient stages of
the decision-making process are the collection of visual and auditory stimuli while receiving information on
investment options, the selection and classification of such stimuli, their processing, and the interpretation.

These phases are influenced by genetic and personality traits, implicit (unaware) memory of experiences, and by
risk, or uncertainty, or ambiguity perception related to the available financial information and the market
context.

The brain automatically and unconsciously does many things before a decision is made and agents are aware of
it. Neurofinance combines financial theories with psychology and neuroscientific insights to explain, in an
interdisciplinary way, the widespread irrationality in the behaviour of financial operators.
Q.Value Investing: Value investing is an investment strategy that involves picking stocks that appear to be
trading for less than their intrinsic or book value.

Principles of Value investing:

*Be Calculative, Not Speculative When Selecting Investments: Value investing must be done intelligently, i.e., it
must be supported by detailed research and analysis.

The focus of value investing is to avoid capital losses and generate adequate returns instead of attempting to pick
high-risk investments with a low probability of generating returns.

Based on these features, value investing is qualitative, calculative, and even predictive to some extent, but it is
definitely not speculative.

*Know The Intrinsic Value Of The Investment Most investors buy and sell investments on the basis of stock price
movements. But, value investors typically believe that the price of a stock generally matches its underlying value,
i.e., its intrinsic value over the long term.

So, if a stock is currently priced at lower than its intrinsic value, then there is a case for buying the stock at this
discounted price.

A value investor never makes a decision based solely on the market price of a stock. Instead, determining the
intrinsic value of a stock is a primary requirement for any value investor.

*Ensure A High Margin Of Safety:The difference between the current market price and the intrinsic value of a
stock is called “margin of safety.” For example, if a stock is currently trading at Rs. 100 and its intrinsic value is Rs.
95, then the margin of safety for the stock is 5%.

Most value investors seek a margin of safety ranging from 30 to 60% when selecting investments. This means
that the margin of safety also represents the potential upside for the asset if the intrinsic value calculations are
correct.

*Focus On Making Long-Term Investments:It can sometimes take some time for a company’s share price to
match its intrinsic value. This can occur due to the state of the economy.

As it can take many years for the market value of a stock to match its intrinsic value, value investing requires
practitioners to be patient and wait. By waiting, value investors give markets sufficient time to recognize the
actual value of the company’s stock.

Patience is the key to achieving success as a value investor.

Do Not Follow The Herd

If an investor prefers to go with the flow, or practices momentum investing, then value investing might not be
the best fit for you. This is primarily because stocks become undervalued when investors are looking elsewhere,
and this has historically occurred many times.

For example, in 2020, the energy, technology, and pharma sectors emerged as the most popular sectors to invest
in. But these were the most ignored sectors multiple times between the 2015 to 2019 period.

So, a good value investor must have the ability to ignore the noise. This way, one can go against the momentum
and the conventional wisdom to seek out investments that no one else is looking at.

Taking such a contrarian stance might even look foolish at times. But to succeed as a value investor, having
confidence in one’s investment choices is more important than the fear of looking foolish. So, while not everyone
can have a contrarian mindset, it is an essential trait for a value investor.

Select Investments That Avoid Loss

For example, if the value of an investor’s portfolio decreased by 30% and then posted gains of 30%, the investor
has actually not reached the break-even point. The value of investments is now lower than the amount that was
initially invested. So, to recover the lost capital, the investor now has to generate higher returns.

But, seeking higher returns from investments usually means taking higher risks, which, can lead to even higher
losses. This is the complex cycle of returns and risk that investors often find themselves in when they lose money
in the stock market.

Successful value investors minimize the risk of big losses by keeping a large margin of safety instead of chasing
speculative opportunities. This can be achieved by focusing on just a few sectors and businesses that they
actually understand.

Even though this might not always result in market-beating growth, avoiding losses puts value investors in a
better position to achieve high risk-adjusted returns.

Understand The Market Dynamics Before Investing

Value investing requires investors to respect the market dynamics and make investment decisions when
conditions are favorable.

Value investors should thus be prepared to hold on to their cash and not make any investments when there are
no viable opportunities.

Know The Reason For Selecting Investments

Value investing is not a passive investment strategy. Instead, stock selection is a critical feature that distinguishes
value investing from other investment styles.
A successful value investor has in-depth knowledge of his investments like

What does the company do?

Who are the competitors?

What is the company’s competitive advantage?

Which valuation model is the best fit for the stock?

Why is the stock selling at a discount? And so on.

Value investor need to stay updated on any recent developments that are affecting the company by reading and
understanding the company’s financial statements, participating in quarterly analyst calls, meeting with the
firm’s management, and interviewing past employees. Additionally, one also needs to get the perspective of
other stakeholders like competitors, suppliers, and customers to get a clear picture of the company’s prospects.

Unfortunately, a majority of investors don’t do this and that is one of the key reasons why value investing and its
practitioners form a very small part of the investing population.