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Why Do Stock Markets Crash?

Between Jan 21st, 2008 and July 6th, 2009, the Sensex witnessed 11 single-day falls of 700+ points. The highest was 1,408.35 points on Jan 21st. In this post, I discuss the simple arguments put forth by Edgar E Peters to understand why such stock market crashes occur, in his book, Fractal Market Analysis.

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It is human nature to try and explain the events that occur around us. Unfortunately, it is also human nature to be opinionated and closed-minded.  We conveniently decided to fit stock market returns into a bell curve and temper our risk and return expectations accordingly and proclaimed the markets as "efficient" and "mean reverting"  because the associated math was convenient (if not simple).

Unfortunately, extreme positive returns (bubbles) or extreme negative returns (as above; crashes) cannot be accommodated within the efficient market hypothesis and they became the proverbial elephant in the room, even after 2008 crash.

Our job as investors is to understand risk as best as we can. There is no need for math or fancy formulae. We just need a "feel" for the risk.  To do that, we must get rid of mental baggage (if any) and begin with an open mind.

Who trades in the stock market?

The day trader who seeks profit by the hour or the day. The short-term investor, retail or institution who seeks profit over a week, a month or year. The long-term investors who wish to buy and "hold".

When are markets stable?

When the day traders dump a security because it is too risky for him to hold, the short-term and long-term investors will step in to buy because it is not a risk in their time-frame. The reverse is also true.  If this process occurs without a blip, there is said to be "enough liquidity" and the market is stable. Sure, it can move up or down by a few points, but nothing dramatic.

When do markets become unstable?

When a short- and long-term investors get scared by a development, they become sellers instead of buyers or holders. Their outlook of the “long-term” has suddenly changed by an unexpected development. Suddenly there is no distinction between a trader and investor. This is results in, what Peters describes as a “free fall” or a stampede.  The notion of a stampede is particularly insightful. A crowd can be managed as long as they do not decide to head for the exit at the same time. Thus, markets become unstable and crash when there is a liquidity crunch. This is what occurred during each of those 11 occasions mentioned above.

Let us not get ahead of ourselves and sound like we are stating a fact. This is a hypothesis – the central idea behind the fractal market hypothesis.

I had introduced the idea of a fractal before.

Fat Tails: The True Nature of Stock Market Returns - Part 1

Fractals: The True Nature of Stock Market Returns - Part 2

The similarity between the returns over minutes, hours, weeks, months and years is referred to as self-similarity. That is the parts appear to be similar to the whole. The idea that traders and investors buy and sell in harmony or share the same risk (adjusted for

The similarity between the returns over minutes, hours, weeks, months and years is referred to as self-similarity (see part 2 above for data). That is the parts appear to be similar to the whole. The idea that traders and investors buy and sell in harmony or share the same risk (adjusted for the duration) is related to this self-similarity (more on this in the coming weeks).

What about the “long-term” trends?

Besides the obvious fact that we will all be dead in the long-term, asset classes that are linked to the economic health of a country tend to exhibit lower risk “over the long term”. This is true of stocks and bonds.

On the other hand, asset classes that do not depend on countries economic health will not exhibit lower risk with longer duration. Examples are currency trading and gold.

These are facts that we will have to incorporate into the fractal market hypothesis. I shall present data to support these in the coming weeks (it is, of course, available in the Peters’s book). I had if you excuse the expression, an orgasm when I saw it for the first time.

Not So Fast!

Now, the financial services industry uses this idea – risk associated with equity investing is lower with increasing duration – to sell mutual funds, ulips and stocks. What we as investors should recognise is, that an unexpected event can trigger a stampede at any time and crash the market. Then years of investing gains would be wiped out in a few days. Therefore risk management is key. For this, we need to understand risk the right way. Hence the need to at least appreciate the bare essentials associated with Fractal Market hypothesis.

To be continued ....

References

  1. Chapter 3 of Fractal Market Analysis: Applying Chaos Theory to Investment and Economics, by Edgar E Peters.
  2. Sensex suffers 12th biggest fall since 2008: http://www.thehindu.com/business/sensex-suffers-12th-biggest-fall-since-2008/article2476576.ece
  3. Biggest falls in Indian stock market history: http://www.rediff.com/money/2008/oct/24bcrisis10.htm

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2 thoughts on “Why Do Stock Markets Crash?

  1. VRock

    I've been following Bill Williams and Elliott waves for a few years now with great results and it blew my mind initially to see how the markets are actually a natural phenomenon. No matter which market you pick, same thing repeats over and over again. Thanks for this post

    Reply
    1. freefincal

      Thank you. Elliot waves are not fractals though. In fact, fractal practitioners are dismissive about their (E waves) ability to predict. I shall post on this in more detail soon. Of course, I cannot comment on your success.

      Reply

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