Modules for Beginners
Navigating Bear Markets
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Lessons from historical bear markets: Global
In the previous chapter of this module, we explored the various historical bear markets that India had seen, and took a closer look at the key lessons that we learnt from them. In this one, however, we’re going to take a look at a few of the global bear markets that we have witnessed through the years and delve into what they have taught us. As with the previous chapter, we’ll first start off with a short overview of each bear market before proceeding to the key takeaway from it.
Lessons from global historical bear markets
While there’s absolutely no dearth of bear markets in the international scene, in this chapter, we’re only going to be focusing on a few of the most important and impactful ones witnessed in the recent past. In keeping with this, we’ll begin with the worst ever bear market, barring The Great Depression that the world has ever witnessed - the financial crisis of 2007-2008.
1. The financial crisis of 2007-2008
Although the origin of this financial crisis was the United States of America, its impact was so huge that markets throughout the world were affected. Let’s attempt to understand the crisis and the bear market that followed.
Basically, the 2007-2008 crisis was brought about by the U.S. financial institutions and the excessive amounts of risks taken by them. A few years prior to the crisis, the U.S. housing market had been witnessing a meteoric rise. This led to these financial institutions giving out too many loans. A huge number of these loans went to subpar borrowers with low credit scores and inadequate repayment abilities. In a bid to insure these less-than-favorable loans, these financial institutions also bought and sold credit default swaps between each other. In other words, the lending institutions involved not only issued loans to parties with credit risk, but also took on additional risk by insuring other institutions guilty of the same lending mistake. This effectively doubled the risk for each such lending institution.
When these loans ultimately went into default, the financial institutions were not able to honor the commitments of the credit default swaps. Such a situation culminated in the failure of several huge financial institutions, the biggest of which was Lehman Brothers.
Key lesson: The sectors in the stock market are interlinked
Though it was the U.S. financial institutions that single-handedly brought about this crisis, it wasn’t the banking sector alone that had to bear the brunt of it. The financial crisis completely shattered the confidence of stock market investors, leading to the stock prices of banks and other financial institutions plummeting.
This forced financial institutions to tighten credit inorder to avoid getting into an insolvency situation again. Due to the nearly complete lack of credit facilities, several businesses failed, international trade declined, the housing market bubble burst, and unemployment went up steeply.
One of the key lessons that investors learnt as a result of this financial crisis was that the sectors in the stock market are invariably interlinked. The failure of a single sector, especially the financial services sector, could have a cascading effect on the other sectors as well. Also, since the U.S. economy is the largest in the world, any sort of negative impact in the American economy has the potential to pull down the global economy. A very good example of this is the failure of European banks as a result of this crisis.
Another major lesson that investors learnt was that while stock diversification works to a certain extent, it doesn’t always protect you from market downsides. This is especially true when all of the sectors take a hit during a bear market. Furthermore, despite all portfolio safeguards, there are some things that are completely beyond your control. All that you can do in such a situation is limit your losses by selling off your holdings before they take a huge hit.
2. The dot-com bubble
The bursting of the dot-com bubble was an infamous bear market scenario back in the early 2000s. Spurred on by the popularization of the internet and growing access to the World Wide Web, many internet companies came into the market in the early 1990s. Investors were keen on putting their money in these companies, backed by a firm belief in technology and its future growth potential. As an increasing amount of capital flowed in, the valuations of these internet companies, many of which were online shopping businesses, shot through the roof, starting from 1995. By the start of the year 2000, these companies were found to be significantly overvalued.
As a result, the Nasdaq Composite stock market index swelled by as much as 400% in response to this manic buying. However, all of that came crashing down at around March, 2000. Both the primary broad market indexes of the U.S. started to fall consistently by several percentage points all throughout 2000, 2001, and 2002. Several internet and communication companies such as Pets.com, Boo.com, Webvan, NorthPoint Communications, and Worldcom, among others had to shut shop.
Key lesson: Fundamental analysis is the holy grail of long-term investing
In a bid to enjoy quick and high profits, investors continued to pour money into these internet companies despite knowing full well that they were overvalued. The key lesson that the dot-com bear market taught us was that there’s absolutely no replacement for fundamental analysis. It reiterated the fact that investors should always carry out a thorough analysis of the fundamentals before investing their hard earned money.
A simple analytical exercise would have clearly brought the overvaluation of these companies to light, thereby preventing investors from buying into these companies. Overlooking the fundamentals and the balance sheets of the companies were widely agreed upon as the reasons that led to the creation and the ultimate bursting of the dot-com bubble.
3. September 11, 2001
Nobody’s a stranger to the events of 9/11. On that fateful day, four coordinated terrorist attacks took place in New York City, completely destroying the twin towers of the World Trade Center. The attacks had immediate and heavy repercussions on the U.S. and global stock markets, leading to huge sell-offs. It is estimated that these attacks caused a loss of over $40 billion for the insurance sector. Several sectors such as insurance, aviation, and tourism, among others were severely impacted as a result of these attacks.
Although the indexes made a bit of recovery after the attacks, the bear market continued to persist and evolved into an international stock market downturn in the year 2002. In addition to the U.S.A, this downturn also impacted stock exchanges in Canada, India, China, and Europe.
Key lesson: Be consistent with your investments
One of the major lessons that investors learnt from the bear markets of 2001 and 2002 was that building positions over a period of time was far better than investing a lump sum amount of money at once. Investors who had put in all of their money into the stock market suffered crippling losses due to this single unexpected event and had to file for bankruptcy.
However, investors who slowly injected funds into the stock market through techniques such as SIPs, fared far better in the long-term. The slow and steady approach towards investing in the stock market allowed investors to weather such flash storms by bringing their overall cost of investment down through rupee-cost or dollar-costs averaging.
With this, we’ve come to the end of yet another chapter on historical bear markets and the lessons that we learnt from them the hard way. In the next chapter, we’ll be focusing on the various investment strategies that you can employ in order to make full use of a bear market.
A quick recap
- Many historical bear markets have also had global repercussions.
- For instance, the 2007-2008 crisis was brought about by the U.S. financial institutions and the excessive amounts of risks taken by them. This market drove home the point that the sectors in the market are all interlinked.
- The bursting of the dot-com bubble was another infamous bear market scenario back in the early 2000s. It reinforced the importance of fundamental analysis for long-term investors.
- The 9/11 attack on the Twin Towers was another bear market trigger, and its key lesson to investors was that a slow and steady approach towards investing in the stock market brings the overall cost of investment down through rupee-cost or dollar-costs averaging.