Anatomy of a financial crisis and what you need to know about it

If you’ve been following the recent market developments, I bet that there’s a good to fair chance where you stopped and ask: “what the frick is going on in the markets”.

To help us answer the question, I’ve read up a bit on market history in hopes that previous crisis would shed some light on what’s going on with the market developments today.

The insights that I’ll be providing today comes from the book: Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics) and in this article, we’ll be looking at the anatomy of a typical crisis.

Anatomy of a typical crisis

1. Start of euphoria – caused by an outside shock to the macroeconomic system – which resulted in an increased optimism towards the economy. This results in an increased in willingness to consume, spend, borrow and invest.

2. Rate of economic growth accelerates as a result of market participants actions. This creates a feedback loop that generates greater optimism.

3. As asset prices increase, an illusion is created in the economy. Businesses now appeared to be more creditworthy while household investors appear to be wealthier. This further lowers the cost of borrowing and increases the volume of investment and consumption by both businesses and household investors as they begin to participate in scramble for the higher rate of returns.

Making money never seemed to be easier.

4. End of the euphoria. As buyers become less eager and seller becomes more eager - an uneasy period of financial distress follows. For an economy as a whole, the equivalent is the awareness that it is time to be more liquid.

This is caused by a realization that the existing model that the economy is running on is not sustainable. This realization can be internal, where market participants slowly realize it themselves, or it can be external, where an external event forces the market participants to acknowledge the reality.

The change of mindset from confidence and pessimism is the source of instability in the markets.

5. Investors start liquidating, in pursuit of higher liquidity, which causes asset prices to decline sharply. This action leads to more bankruptcy for highly leveraged investors and businesses.

The prices of the securities may begin to increase again as some investors continue to hold on to the assets and even buy more from the belief that the decline in prices is temporary, a hiccup.

6. As prices continue to decline, more and more investors realize that prices are unlikely to increase and that they should sell before prices decline further. The race out of real or long-term financial securities and into money may turn into a stampede.

7. Banks become more cautious in their lending and the sudden tightening of the supply of credit may lead to panic.

9. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until the lender of last resorts succeeds in convincing investors that the money will be made available in amounts needed to meet the demand for cash

Thoughts on current developments

As there is only so much I can cover in a short article, here are my thoughts.

Looking at the above anatomy, I suspect that the market is currently at the euphoria stages. Thanks to the government interventions, investors are now dumping in money without much due consideration of what is happening in the economy.

As a result of their actions – both spending and investing – it is likely that the “recovery” that everyone is hoping for will most likely occur, provided that there are no hiccups along the way which may result in a sudden change in market sentiment and confidence in a direction that causes a negative feedback loop to occur.

While the current trend is definitely pointing towards a more bullish market, I personally think that investors should tread with care. On one hand, it is foolish to go against the current market trends even if it is deviating from actual economic developments. But on the other hand, it is also equally foolish to ignore what is actually happening in the economy as ultimately, what happens in the main streets will affect consumer and investors sentiment, which is the main driver of wall street performances.

Apart from simply praying that the music doesn’t stop, I think investors should position themselves carefully – by selecting proper underlying investments – and manage their risk in a manner that best reflects the amount of risk and reward that is relevant to their own financial plans.

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Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner, who specializes in retirement and investment planning. Find out more here.

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Disclaimer:

This article is meant to be the opinion of the author and is for information purposes only.

This article should not be seen as a financial advice

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