Booms and Busts, and What Investors Should Do About Them
During the first part of 2016, the stock market has had drastic ups and downs, making investors nervous with its volatility. However, markets have faced extreme changes before, throughout the centuries. What should investors expect in these difficult times? How can you prepare for these wild fluctuations in the market?
HISTORY OF MARKET BOOMS AND BUSTS
We have all heard or read about major occasions where the market fell or rose dramatically. Markets can (and do) rise, of course, due to strong economies. These are good market booms. However, sometimes there are market bubbles, the unreasonable market booms. Bubbles occur when investors pour money into a specific stock or market segment, way beyond the actual value of the particular businesses and products. “Asset euphoria” has been used to describe investor interest in a bubble stock or sector. Like soap bubbles, investing bubbles keep growing but eventually pop because there is nothing substantial holding them up. Here are some examples:
Tulip bulb mania (Holland, 1630s) – Holland’s upper classes competed for the rarest bulbs, after tulips had become a status symbol. Tulip bulbs were then traded on Dutch stock exchanges, so all members of society were encouraged to speculate on them. At the height of the market, tulip bulbs traded for several times the average Dutch annual salary. However, tulip bulb prices eventually dropped. Panic selling set in, which left many investors in financial ruin.
Mississippi Company (France, 1719-1720) – The French economy was in dire straits, and the national debt was restructured under the auspices of the Mississippi Company, which was given exclusive trading rights for the various French colonies. Numerous continental traders rushed to buy shares in the Mississippi Company and soon the stock was worth 80 times as much as all the gold and silver in France, so the French government could not cover its debt (the shares in the company). The value of the shares plummeted, and investors took substantial losses.
Dot.com Bubble (2000-2002) – The excitement of the Internet, with its promise of an international market for goods and fascinating new ways of communication, overwhelmed many investors. Investors blindly bought newly issued stock from the IPOs of Internet companies and markets zoomed upward. Unfortunately, these investors never bothered to look over the companies’ business plans. Unable to actually make money, many of these Internet companies reported huge losses and began to fold.
Housing and Mortgage Crisis (2007-2009 or 2007-present?) – Rising home prices led to rampant real estate speculation and a housing boom. This housing boom and low interest rate sled many lenders to offer home loans to people with poor credit. Investor firms bought these loans, then sold them as mortgage-backed securities to large investors. When payments began to catch up with home buyers who could not afford them, foreclosures jumped dramatically, which led to enormous losses by banks and investment firms that traded in these mortgage-backed securities. Many people lost their homes, and many banks lost lots of money. This led to a global credit crisis.
How could investors NOT see these things happening? How could this “asset euphoria” have continued? It is obvious to us now why the busts happened and what we would have done differently, had we been there. However, even the wisest investors found it difficult to imagine the massive problems that would develop. We can quantify, analyze, and monitor market trends, but we cannot predict the future. All that investors (and their financial advisors) can do is to be ready for changes in the market, whether mild or massive.
MARKET IN 2016
Investors went for a wild ride in the first quarter of 2016. In January, stocks fell lower due to fears of global recession and in reaction to the Federal Reserve’s increase in interest rates. The market rallied in February, fell again in February, then moved steadily upward in March, reaching levels similar to the beginning of the year.
This past week, however, we learned that corporate defaults had reached a seven-year high. More companies have defaulted on their debts so far in 2016 than during the start of any year since 2009. Over half of these defaults have come from oil, gas, and mining companies. Commodities have slid, and crude oil hit its lowest price level in over a decade.
Energy companies and the MLP companies (Master Limited Partnerships) that own many of the pipelines and energy processing plants have done well in recent years. Is their success part of an energy bubble? Some observers speculate that this energy bubble might be bursting. Others, however, note that commentators have cautioned about imminent energy busts for the past five years. As with any market sector, wise investors should consult with their financial advisors about energy-related holdings.
Another big development relates to the Housing and Mortgage Crisis discussed earlier. In early April 2016, Goldman Sachs agreed to a $5 billion fine for its faulty mortgage practices. Although the firm knew that many of the home loans backed by mortgage-backed securities were in danger of failing, it continued to approve every mortgage-backed security issued. Four other Wall Street giants have also paid multi billion dollar fines for their roles in the Mortgage Crisis, including Bank of America, Citigroup,JP Morgan Chase, and Wells Fargo. So, almost 10 years later, we are still cleaning up the housing and mortgage mess.
PREPARING FOR THE BOOMS AND THE BUSTS
How does a wise investor prepare to enjoy any booms and protect against any busts?
To avoid falling prey to the lure of “asset euphoria,” as seen with the bubbles described above, remember the adage: “If it sounds too good to be true, then it probably is.”Discuss this with your financial advisor.
To avoid losing large amounts of money due to market changes, the best move is to diversify your holdings. Diversifying your assets among various types of investments allows you to get a better risk-adjusted return. You spread the risks around. Over the long term, you will reap the benefits of many investment sectors, rather than suffer massive losses when a bubble bursts in one of them. Your financial advisor is an expert on diversifying your investments by investing wisely in various sectors.
Just imagine how much better off the tulip bulb, Mississippi Company, Dot.com, and mortgage-backed security investors would have been if they had actually pondered how something can sound “too good to be true”. And even if they ignored that warning and jumped for the new asset, just imagine how much better off they would have been with a diversified set of investments. They would face crushing financial losses, but only in one part of their financial portfolios.
To balance your investment impulses and to diversify your holdings properly, the best move is to see your financial advisor.