STOCK MARKET CRASHES

Investment Banking & Security Analysis

Submitted to: Sir Fawad Fazal Submitted by: Zarish Safdar (6939) Muhammad Ahsan Khanzada (7710)

LETTER OF ACKNOWLEDGEMENT

Institute of Business Management Korangi Creek, Karachi-75190, Pakistan UAN (9221)111-002-004, Fax: (9221) 509-0968 Http://www.iobm.edu.pk

December 31, 2011 Firstly we would like to thank our instructors Mr. Fawad Fazal for molding our thoughts intellectually and spiritually. Our instructor guided and helped us with her professional skills at every stage of making the report and it is an honor being blessed with such instructor. He was a great source of inspiration in our work. An effort has been made to the utmost level in this report to cover the most important pointers that we have learnt from this course. And we have tried our level best to come up to all of your expectations and this will be proved from our report. Sincerely yours, Zarish Safdar (6939) Muhammad Ahsan Khanzada (7710)

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LETTER OF TRANSMITTAL

Institute of Business Management Korangi Creek, Karachi-75190, Pakistan UAN (9221)111-002-004, Fax: (9221) 509-0968 Http://www.iobm.edu.pk

December 31, 2011 Sir Fawad Fazal Lecturer, Finance Department Institute of Business Management Karachi.

Dear Sir, The reports topic was Stock Market Crashes. The main objective of this report was to find out the common and exclusive points between the four well known stock market crashes and lessons learned from these historic crises. If you have any queries or doubts about the compilation of this report you may feel free to contact us at the emails below. Sincerely, Ahsan Khanzada (std_7710@iobm.edu.pk) Zarish Safdar (std_6939@iobm.edu.pk)

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TABLE OF CONTENTS

STOCK MARKET CRASH ............................................................................................... 5 DILEMMA FACED BY INVESTORS ............................................................................. 5 CRASH OF 1929 ................................................................................................................. 6 EXCLUSIVITY ...................................................................................................................... 8 CRASH OF 19731974 ....................................................................................................... 9 EXCLUSIVITY ...................................................................................................................... 9 CRASH OF 1987 ............................................................................................................... 10 EXCLUSIVITY .................................................................................................................... 11 CRASH OF 2007-2009 ...................................................................................................... 12 EXCLUSIVITY .................................................................................................................... 14 COMMONALITIES BETWEEN THE FOUR CRASHES .......................................... 15 LESSONS LEARNED FROM THE CRISES ................................................................ 16 CONCLUSION .................................................................................................................. 19

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STOCK MARKET CRASH

Stock Market Crash refers to a rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, economic crisis or the collapse of a long-term speculative bubble. Well-known U.S. stock market crashes include the market crash of 1929 and Black Monday (1987). Stock market crashes wipe out equityinvestment values and are most harmful to those who rely on investment returns for retirement. Although the collapse of equity prices can occur over a day or a year, crashes are often followed by a recession or depression.

DILEMMA FACED BY INVESTORS

Over the last hundred years, there have been several large stock market crashes that have plagued the American financial system. For example, during the Great Depression, stock prices dropped to 10% of their previous highs and during the crash of 1987, the market fell more than 20% in one day. Due to the way stocks are traded, investors can lose quite a bit of money if they don't understand how fluctuating share prices affect their wealth. In the simplest sense, investors buy shares at a certain price and can then sell the shares to realize capital gains. However, if the share price drops dramatically, the investor will not realize a gain; in fact, the investor will lose money. For example, suppose that an investor buys 1,000 shares in a company for a total of $1,000. Due to a stock market crash, the price of the shares drops 75%. As a result, the investor's position falls from 1,000 shares worth $1,000 to 1,000 shares worth $250. In this case, if the investor sells the position, he or she will incur a net loss of $750. Another way that an investor can lose large amounts of money as a result of a stock market crash is by buying on margin. In this investment strategy, investors borrow money in order to make a profit. More specifically, an investor pools his or her own money along with a very large amount of borrowed money in order to make a profit on small gains in the stock market. Once the investor sells the position and repays the loan and interest, a small profit will remain. For example, if an investor borrows $999 from the bank (at 5% interest) and then combines it with $1 of his or her own savings, that investor will have $1,000 available for investment purposes. If that money is invested in a stock that yields a 6% return, the investor will receive a total of $1,060. After returning the loan (with interest), about $11 will be left over as profit. Based on the investor's personal investment of $1, this would represent a return of more than 1000%.

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This strategy certainly works if the market goes up, but if the market crashes, the investor will be in a lot of trouble. For example, if the value of the $1,000 investment drops to $100, the investor will not only loses the dollar he or she contributed personally, but will also owe more than $950 to the bank (that's $950 owed on an initial amount of only $1 provided by the investor). In the events leading up to the Great Depression, many investors used very large margin positions in order to take advantage of this strategy. However, when the depression hit, these investors worsened their overall financial situations, because not only did they lose everything they owned, they also owed large amounts of money. Because lending institutions could not get any money back from investors, many banks had to declare bankruptcy. In order to prevent such events from occurring again, the Securities and Exchange Commission made regulations that prevent investors from taking large positions on margin.

CRASH OF 1929
The stock market crash of October 1929 is often seen as the end of the prosperity of the 1920s. However, there were many signs that the economy was already on the way down before the crash. The two worst days were October 24, 1929 (Black Thursday), and October 29, 1929 (Black Tuesday). Stock prices increased dramatically in 1928, with the Dow Jones Industrial Average reaching a peak of 381.2 on September 3. Stock prices fell by about 10 percent following this peak, but then rose again by about 8 percent by mid-October. Panic selling appears to have set in on October 23, and on October 24 a record-breaking 13 million shares were traded, compared to an average of 4 million shares per day in September. The technology of the day (telephone and telegraph lines) was not able to keep up with the trading, and the ticker tape ran an hour and a half late. Many sellers did not learn of the prices they received for their trades until later that night. Several of the nation's largest bankers were alerted to the crisis and announced that they were willing to buy stocks above the going prices.

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The intent of the bankers was to give people confidence in the market and thus prevent panic selling. On October 25, President Hoover also tried to halt the panic selling by reassuring people that the fundamental business of the country that is, the production and distribution of goods and services is on a sound and prosperous basis. Although prices steadied for a few days, panic selling started again on October 28. Nearly 16.5 million shares were traded on October 29, and the downward trend in stock prices continued. Two weeks after the crash, the average prices of leading stocks were about half of what they had been in September. After the stock market crash of 1929, things only got worse. By the end of 1929 the market recovered somewhat, but in general stock prices continued in a downward spiral until 1932. By 1932 average stock prices had fallen more than 75 percent, people had lost an estimated $45 billion in wealth and the market did not reach its 1929 peak level for another 25 years. Economists generally do not view the crash of 1929 as a cause of the Great Depression, but they agree that the fall in stock prices made the situation worse. The optimism and hope of the 1920s gave way to feelings of skepticism and uncertainty. Consumers and businesses were less willing and less able to spend money, given their losses and their lack of confidence in the economy. Banks lost vast amounts in the crash also, and did not have the liquidity they needed to make loans to tide people over until the market recovered. Many banks subsequently failed. The resulting decrease in consumption and investment spending, and an increased desire to hold cash balances outside the banking system, led to a downward spiral of declining production, increased unemployment and falling prices. The crash on Wall Street also led to stock market crashes around the world: first in London, then in Paris, Berlin and Tokyo. Several reforms were implemented after the crash, intended to prevent further stock market crashes. The Glass-Steagall Act of 1933 prohibited banks that are members of the Federal Reserve from affiliating with companies whose major purpose is to sell stocks. The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) to protect the public against misconduct in the securities and financial markets. This act also required the Federal Reserve to regulate margin requirements in order to reduce speculation.

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Exclusivity
Many economists believe that Federal Reserve policies led to the stock market crash of 1929 and were a main cause of the Great Depression that followed. Prior to the stock market crash, in 1928, the Fed decreased the money supply in the economy in part to try to discourage stock market speculation. This tight monetary policy probably contributed to falling stock prices in 1929, because it made it more difficult for people to borrow money to buy stocks. Economists disagree about the causes of the stock market crash of 1929. They agree, however, that there was no single, dominant cause, and that many factors worked together to bring the market down. Here are some of the exclusive reasons for 1929 crash:

1) Federal Reserve policies: The tight monetary policy of the Federal Reserve prior to the crash may have led to the crash. The Fed caused interest rates to rise because it wanted to curb speculation in the stock market late in the1920s. This may have led to a decrease in demand for stocks and falling prices. 2) The Smoot Hawley Tariff Act: This act, meant to stimulate U.S. production, would impose high tariffs on imports. Investors were concerned that if it passed (it did pass in 1930), the profits of exporting companies would fall and other countries would retaliate by refusing to buy U.S. goods. This expectation of lower profits in the exporting sector may have caused people to sell their stocks.

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CRASH OF 19731974
The 19731974 was a stock market crash that lasted between January 1973 and December 1974. Affecting all the major stock markets in the world, particularly the United Kingdom, it was one of the worst stock market downturns in modern history. The crash came after the collapse of The Breton Woods system United States dollar devaluation under the Smithsonian Agreement. It was compounded by the outbreak of the 1973 oil crisis in October of that year. It had the worst effect in the United Kingdom, and particularly on the London Stock Exchange FT 30, which lost 73% of its value during the crash. From a position of 5.1% real GDP growth in 1972, the UK went into recession in 1974, with GDP falling by 1.1%. At the time, property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders. In the United Kingdom, the crash ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices; over the following year, stock prices rose by 150%. However, unlike in the United States, inflation continued to rise, to 25% in 1975, giving way to the era of stagflation.

Exclusivity
1) This crash was unique in a sense that it was not because of speculative hike in prices but had some very different incidents; like oil crises, real estate issues. 2) Overall stocks went down by 73% and by December 1975 they gained 43%, long term position may save you from this crash.

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CRASH OF 1987
Crash of 1987 was a rapid and severe downturn in stock prices that occurred in late October of 1987. After five days of intensifying stock market declines, selling pressure hit a peak on October 19, known as Black Monday. The Dow Jones Industrial Average (DJIA) fell a record 22% on that day alone, with many stocks halted during the day as order imbalances prevented true price discovery. That event marked the beginning of a global stock market decline, making Black Monday one of the most notorious days in recent financial history. By the end of the month, most of the major exchanges had dropped more than 20%. Interestingly enough, the cause of the massive drop cannot be attributed to any single news event because no major news event was released on the weekend preceding the crash. While there are many theories that attempt to explain why the crash happened, most agree that mass panic caused the crash to escalate. Since Black Monday, a number of protective mechanisms have been built into the market to prevent panic selling, such as trading curbs and circuit breakers. People speculate on the exact causes of the crash, which was rare in that the market made up most of its losses rather quickly, rather than preceding a protracted economic recession. Some people point to the lack of trading curbs, which markets have today, and automatic trading programs in place at the time as possible culprits. The lead-up to October 1987 saw the DJIA more than triple in five years, and price/earnings (P/E) multiples on stocks had reached above 20, implying very bullish sentiment. And while the crash began as a U.S. phenomenon, it quickly affected stock markets around the globe; 19 of the 20 largest markets in the world saw stock market declines of 20% or more. Investors and regulators learned a lot from the 1987 crash, specifically with regards to the dangers of automatic or program trading. In these types of programs, human decisionmaking is taken out of the equation, and buy or sell orders are generated automatically based on the levels of benchmark indexes or specific stocks. In a disorderly market, humans are needed more than ever to assess the situation and possibly override imprudent market thresholds. Stock prices had risen dramatically in the first half of 1987, with the Dow Jones Industrial Average reaching a peak of 2,722.44 on August 25. During the next five weeks prices fell by about 8 percent, but then rose again by about 6 percent. Prices fell steadily the following week. But on October 19, stock prices fell more than on any other single day in the twentieth century. The Dow Jones Industrial Average fell a record 508.32 points, closing at 1,738.

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This represented a one-day drop of 22.6 percent in the value of stocks nearly doubles the one-day loss record set during the crash of 1929. Over 604 million shares were traded on the New York Stock Exchange alone, shattering previous volume records. Some of the volume was caused by panic selling, as investors tried to sell before prices fell further. Some of the selling was done automatically by computers programmed to sell if prices fell below certain levels. Phone networks and computers were jammed for hours because of the unprecedented volume of trades, and many people who tried to trade were unable to do so. Investors lost an estimated $500 billion in share values in that one day. In many ways, this crash amounted to the nation's worst financial crisis since the Great Depression. Losses immediately affected markets around the world, thanks to electronic links and global communication networks.

Exclusivity
The stock market crash of 1987 was relatively painless largely because the Federal Reserve moved quickly to ease monetary policy and reassure banks. These policies probably prevented big declines in consumption and investment spending that might otherwise have been triggered by the loss of wealth from the crash. The fact that no recession followed the crash of 1987 is often attributed to the competent actions of the Fed immediately following the crash. Here are some of the exclusive reasons for 1987 crash: 1) Federal Reserve policies: The Federal Reserves announcement of an increase in the discount rate from 5.5 percent to 6 percent on September 4, 1987, was unnecessary. It may have signaled to people that the Fed thought high inflation was going to return. Investors may have decided to sell their stock because of the Feds announcement.

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2) Programmed and computer trading: Large institutional investing companies programmed their computers to order large stock trades automatically when stock prices reached certain levels. As prices fell on October 19, sell trade orders came in automatically, jamming the system and causing more panic among investors. 3) A debt-ridden economy: Both the trade deficit and government budget deficits were increasing rapidly. Investors may have feared that the prices of U.S. stocks would fall relative to foreign stocks. Anxiety over these growing debts in the third quarter of 1987 may have led to the stock sell-off.

CRASH OF 2007-2009
The S&P 500 declined 57% from its high in October 2007 of 1576 to its low in March 2009 of 676; many indicators of credit risk such as the "Ted Spread" or the option adjusted spread (OAS) on corporate bonds reached record highs. Frequently more than one factor is present, and each factor can multiply the damage caused by one of the others. Following the bursting of the tech bubble and the recession of the early 2000s, the Federal Reserve kept short-term interest rates low for an extended period of time. This coincided with a global savings glut, as developing countries and commodity producing nations accumulated large financial reserves. As these excess savings were invested, global interest rates declined to record low levels. Frustrated with low returns, investors began to assume more risk by seeking higher returns wherever they could be found. For several years, global financial markets entered a period which came to be called the "Great Moderation" due to the above-average returns and below-average volatility demonstrated by a wide variety of asset classes. In the United States, the Great Moderation coincided with a housing boom, as prices soared (particularly on the two coasts and in cities such as Phoenix and Las Vegas.) Rising home prices led to rampant real estate speculation, and also fueled excessive consumer spending as people began to view their homes as a "piggy bank" that they could extract cash from to fuel discretionary purchases. As home prices soared and many homeowners "stretched" to make their mortgage payments, the possibility of a collapse grew. However, the true extent of the danger was hidden because so many mortgages had been securitized and turned into AAA-rated securities. When the long held belief that home prices do not decline turned out to be inaccurate, prices on mortgage-backed securities plunged, prompting large losses for banks and other financial institutions. These losses soon spread to other asset classes, fueling a crisis of confidence in the health of many of the worlds largest banks.

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Events reached their climax with the bankruptcy of Lehman Brothers in September 2008, which resulted in a credit freeze that brought the global financial system to the brink of complete collapse. Unprecedented central bank actions combined with fiscal stimulus (notably in the US and China) helped ease some of the panic in the market place, but by late winter 2009, widespread rumors surfaced that Citigroup (NYSE:C), Bank of America (NYSE:BAC), and other large banks would have to be nationalized if the global economy was to survive. Fortunately, the aggressive actions by governments around the world eventually helped avoid financial collapse, but the credit freeze forced the global economy into the worst recession since WW2. The credit crisis and accompanying recession caused unprecedented volatility in financial markets. Stocks fell 50% or more from their highs through March 2009 before rallying more than 50% once the crisis began to ease. In addition to stocks, most fixed income markets also displayed unprecedented volatility, with many corporate bond markets at one point forecasting bankruptcies at a level not seen since the Great Depression. Oil fell 70%, then doubled as the financial system stabilized. The events of the housing bubble and credit crisis are likely to resonate with consumers and investors for years to come. In many countries (including the U.S.) consumers remain heavily leveraged and many homeowners are "underwater." As consumers deleverage and repair their finances, their purchasing patterns will be permanently altered. Many developed market countries have also seen a substantial deterioration in their fiscal position. While government actions helped prevent worst-case outcomes from the credit crisis, large budget deficits now represent a structural problem that may take decades to solve. Finally, investors have experienced the most volatile and frightening markets of their life. Positive lessons, such as the importance of diversification and independent analysis can be taken from the crisis, but there are also emotional affects that must be considered. In particular, investors must remember that the events of the crisis were unusual and are unlikely to be repeated; while excessive greed in the financial markets is inappropriate, so too is excessive fear. Investors that can incorporate the lessons of the credit crisis without having their emotions unduly influenced will be best positioned for future investment success.

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Exclusivity
1) Asset/Liability Mismatch: An asset/liability mismatch occurs when there is a wide differential margin between the duration of a financial institution's loans and investments and its deposits or other funding sources. This factor was present in the 2007 collapse of Bear Stearns and the 2008 Lehman Brothers bankruptcy and Goldman Sachs and Morgan Stanley chose to become bank holding companies. Both of these firms were highly dependent on short-term financing to conduct their operations. However, the assets that they held proved to be illiquid during the credit crisis, and were therefore effectively long-term in nature. This mismatch between the firms' assets and liabilities directly contributed to their bankruptcies 2) Excessive Risk: Excessive risk occurred unintentionally; investment banks and other financial institutions that purchased mortgage-backed securities prior to the 2008 credit crisis believed they were safe. However, when extraordinarily high volatility hit the financial markets in 2007, all of trades began to move in the same direction, prompting massive losses and fears of a systemic financial collapse. Excessive leverage also exacerbated the asset/liability mismatch at Bear Stearns and Lehman Brothers.

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COMMONALITIES BETWEEN THE FOUR CRASHES

1) Margin buying: People could buy stock by paying as little as 10 percent down on the purchase price, borrowing the other 90 percent. When stock prices fell, stocks soon weren't worth enough to enable people to pay back the loans. People scrambled to sell their stocks before prices fell even further. So this borrowing percentage should decrease to 50 or 60 %. To increase ownership of investor in stocks. 2) Psychological reasons: When panic sets in, people may react irrationally. When people saw others selling, they worried that they should sell too before things got worse. This panic selling caused prices to fall just what people were hoping to avoid. 3) Inflationary fears: Many investors were concerned that the inflation of the 1970s and early 1980s would return, and inflationary fears cause interest rates to rise. The long-term rate on some bonds reached a peak of 10.5 percent on the morning of October 19. This may have caused people to sell stock so that they could invest in bonds and other interest-earning assets instead. 4) Stocks were overvalued: 1974-74 crash can be exception otherwise we have seen that stocks were overpriced in all three crashes. E.g. from 1926 to 1929 stocks were gone up by over 100% and actual performance of the company not following it. The rise in stock prices in the 1980s was also caused by speculation and investors trying to find a way to get rich quickly. In October 1987, stock prices were far too high compared to their earnings and dividends, so prices were bound to fall at some point. 5) The general state of the economy: Stock exchange is reflection of economic performance, in all crashes we have seen that economy has started performing low. Signs of a recession were evident in all of these crashes. Production was falling, prices were falling and personal income was falling. Several prominent public figures stated publicly that they thought bad times were ahead. These signs may have urged stock sell-offs.

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LESSONS LEARNED FROM THE CRISES

Stock market crash chart is very valuable when you want to see what happened with stock prices during periods of great fear. There were several market crashes in last hundred years and decades. It is madness to think that crashes will not come. They will come again and again. Therefore we think that passive investors but also active investors and traders could find several valuable lessons when looking on stock market crash charts. 1. "This time is different" It is very common to hear this sentence. Every decade after some strong boom in one of more areas of economy you will find people telling such sentence. Do not believe it. It is not different. History of stock market crashes shows us that some crashes will come again. When you will hear such sentence, evaluate the area of economy to which it is pointed and then wait for bursting of the bubble. 2. The prices can go only up It is also not true. What is going up will also go down. It is correct the there are strong midterm trend moves on the market accompanied by pullbacks. But every trend will finish and change into opposite. There are also times of bear trend on the market. 3. Fear is much stronger emotion then greed Stock prices move up slowly. But when stock prices change their trend, down moves are much stronger and price move down much more quickly. 4. Diversification will not help during panic Panic moves across asset class universe. Do not expect that you will be safe with commodities when stocks will be in panic selling. There are only few safe heavens and they are also not working all the time. I would mention US 10year Treasury Bonds or German Bunds - i.e. fixed income products issues by governments of USA and Germany. 5. What rise too much up will go down very quickly and a lot Just check some manias. Internet bubble moved price of NASDAQ index up during 6 months in final part of bubble during 1999 - 2000 only to erase these gains in 3 weeks. The same happened in 2008 when during 2008 panic SP500 index erased gains of last several years.

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6. It can take long time before price will recover to pre-crash levels Sometimes there is only mini crash which last only few days of weeks and then price recovers again within few months. But it can take years to recover from big crashes and as you can see NASDAQ is still under 50% of his peak from 2000 bubble. And it is already more than 10 years (2011).

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CONCLUSION
After studying these four crashes we have conclusion that though many factors are similar but core reasons were different, in 1929 it was declining retail sales, in 1973-74 it was oil crises, in 1987 main reason was rise in interest rates along with programmed computer trading, while in 2007 it was derivatives. First off, we should point out that most market volatility is our entire fault. In reality, people create most of the risk in the market place by inflating stock prices beyond the value of the underlying company. When stocks are flying through the stratosphere like rockets, it is usually a sign of a bubble. That's not to say that stocks cannot legitimately enjoy a huge leap in value, but this leap should be justified by the prospects of the underlying companies, not just by a mass of investors following each other. The unreasonable belief in the possibility of getting rich quick is the primary reason people get burned by market crashes. Remember that if you put your money into investments that have a high potential for returns, you must also be willing to bear a high chance of losing it all. Another observation we should make is that regardless of our measures to correct the problems, the time between crashes has decreased. We had centuries between fiascoes, then decades, then years. We cannot say whether this foretells anything dire for the future, but the best thing you can do is keep yourself educated, informed, and well-practiced in doing research. The bottom line, dont trust others with your finances. Do your own research, become financially educated, and you will be able to spot hidden opportunities that the vast majority of others miss out on. While the historic stock prices have generally show good rates of return, it doesnt take much to wipe out a whole portfolio. Make sure you know what to look for when you enter the exciting world of investing.

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