Daniel Lee

Dec 3, 20219 min read

How You Can Spot And Prepare For A Financial Crisis

Watch it on YouTube

1. Introduction

In today’s video, we will be looking at the basics of a financial crisis and how you can prepare and protect yourself against one

In particular, we will be looking at what a financial crisis is and also the anatomy of a financial crisis.

We will also be going through a case study of the year 2000 Dot com bust and draw parallels between the past and the present.

Last but not least we will look at how you can position yourself and prepare for a financial crisis of the future.

Without further ado let’s get started

2. What is a financial crisis?

A financial crisis occurs when financial instruments and assets like your stocks, bonds and real estate’s decrease significantly in value.

A financial crisis is often associated with widespread panic during which investors sell off their assets because they fear that the value of those assets will drop if they remain invested.

Though not exhaustive, the cause of a financial crisis often can be traced to two sources

1) Unsustainable prices caused by investors either from their blind investments or excessive speculations

2) Systematic failures caused by unsustainable business models and operations

To understand how you can spot and prepare for the next financial crisis, you need to understand the anatomy of a financial crisis which brings me to my next point.

3. Anatomy of a financial crisis

What are the recipe and steps to cook up a perfect financial crisis?

While every financial crisis is nurtured and imploded by different factors of their respective times, there are common characteristics, patterns and phases that the economy or market goes through before the eventual financial crisis occurs.

You need to have a good understanding of each phase for you to be able to spot and prepare for the next financial crisis while it is brewing.

Every good financial crisis story has two parts.

The first part is the nurturing part and it begins with a positive external shock that increases the optimism of the market participants towards the economy which results in actions that cause the economic progress to become unsustainable.

The second part is the imploding part and it begins with the realization that the economy is unsustainable and things need to come back down to normal levels where it is healthy for any future economic progress to be sustainable.

To give you an analogy, the first part is kind of like when you started to lose control of your diet which results in obesity but you simply don’t care because the food is too good to not eat.

The second part is kind of like the shit hits the fan moment when you suffer from a heart attack which made you realize that your actions today are not sustainable and that you need to cut down on your diet and exercise to prevent your premature death.

So, let’s go through the first part – the nurturing of a financial crisis.

3.1 Part 1: Nurturing a financial crisis

The first part of brewing a financial crisis is the nurturing part and it begins with a positive external shock that increases the optimism of the market participants towards the economy.

With a newfound mentality that the economy is going to be strong and that they are going to do well financially, people will become more willing to consume, spend, borrow and invest.

As a direct result of the market participants action, the economic activity increases and the growth rate accelerates. This reinforces their previous belief that the economy is doing well and will continue to perform indefinitely.

Because of that validation, the market participants become even more aggressive with their consumption, spending, borrowing and investments and that’s how the positive feedback loop begins.

In moderation, the increase in consumption, spending, borrowing and investments of the market participants are healthy and necessary for sustainable economic growth.

The problem comes when the market participants get a little bit too greedy and goes above and beyond their means – spending more than what they can afford or taking on more risk than what they should.

When the market participants like your investors, businesses and consumers get overwhelmed by the ongoing hype and euphoria, it creates an environment for widespread negligent and fraudulent behaviours that create unsustainable economic conditions that are extremely fragile and destined to collapse.

On average, periods of euphoria can last up to 3 to 4 years hence saying the classic saying of the market can remain irrational longer than you can remain solvent.

Now that the economy has become the equivalent of a house of cards, all you need is a small push to topple the entire structure. That brings me to the second part of the anatomy of a financial crisis.

3.2 Part 2: Imploding back to normalcy

Just as trends die down, the hype and the euphoria experienced by the market participants today will eventually slow down and come to a halt as people start to realize 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.

When that happens, they will become less aggressive and more defensive with their consumption, spending, borrowing and investment.

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

Investors will start to sell off their risky investments and move into safer asset classes like government bonds and businesses will start to slow down their investments as well to avoid taking on additional risks.

As a result of the increase in selling pressure and the decrease in investments made by both businesses and retail investors, asset prices will start to decrease.

The first party to feel these pinches are the highly leveraged investors and businesses, who may be unable to meet the sudden margin call as a result of the decrease in asset prices. As a result, they may be forced to sell off their investments or even file for bankruptcy.

When that happens, asset prices will continue to decline further and this will trigger a race out of riskier asset classes like stock and real estate and into safer asset classes like bonds and deposits as investors realize that the asset prices are unlikely to increase further and they should sell off first before things get worst.

In times where asset prices are declining with no end in sight, banks will also become more cautious in terms of their lending. The sudden tightening of the supply of credit will lead to higher bankruptcy and greater panic as the people who were previously dependant on the bank’s credit for liquidity are now in trouble.

The panic continues to feed 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.

Typically, a financial crisis may last on average about 18 to 24 months with asset prices falling about 30 to 50% over this course of duration.

Now that you have a general understanding of the characteristics, patterns and phases of a financial crisis, let us take a look at an example of the past financial crisis and see how this model applies.

In particular, we will be examining the 2000 dot com bust given the parallel of what had happened previously and what is currently happening today.

As I explain what transpired in the dot com bust, I want you to think about what you are experiencing today to see if you can draw any parallel between the past and the present

4. Year 2000 Dot Com Bust

The year 2000 dot com financial crisis story is a story of paying too high of a price for a business model that is unsustainable.

The rise of the use of the internet was the external trigger that cause the increase in optimism and hype and started the positive feedback loop.

The hype and optimism surrounding anything that associates with the internet led to the huge influx of investment in companies without a proper business plan, product, track record or the most basic profitability.

Despite having nothing to show for, the stock price of companies that associates themselves with the internet often increase up to 4-500% over a short duration of time thereby attracting more investors to invest in hopes of making a quick buck.

Eventually, as the broader economy started to slow down, people started to realize that they are investing in unsustainable businesses and paying too high of a price for something that may not be worth as much.

As a result, of this realization, investors started to take profits and the share price started to drop and banks also started to stop lending money to tech companies that have no proper business model and track record.

Eventually, because of this tightening of the supply of credit, it killed off businesses that have an unsustainable business model and companies started to file for bankruptcy which further fueled the panic and accelerated the race out of stocks.

After 24 months of price decline and a 50% decline from the previous high for the S&P 500, the dot com financial crisis eventually came to a conclusion as investors once again invested again given the attractive price levels and valuations following the crisis.

That covers the 2000 dot combust.

5. What’s happening today

Having gone through the dot com financial crisis story, doesn’t it sound familiar as to what is happening today?

While the scale is of course different as compared to what has happened back in 2000 – in terms of the number of unprofitable businesses with unsustainable business models – the action of the investors today is somewhat similar to the actions of the investors in the year 2000.

As a result, valuations are at an all-time high as people are pricing for perfection with the new narrative today being the “post-pandemic recovery” instead of the previous “rise of the internet”

Now, while there is no guarantee that this will result in the next financial crisis, we cannot ignore the fact that the probability of a financial crisis happening is increasing because of the actions of the market participants today.

Nothing good ever happens when people blindly invest in things without taking into account the price that they are paying for and the worth of the things that they are investing in.

Instead of trying to predict when the next financial crisis may happen, a better option for us is to think about how we can position ourselves and prepare for the next potential financial crisis based on our analysis of the probability of its occurrence given the current market situation.

6. How can you prepare for a financial crisis?

If, based on your analysis, you feel that the current economy and the market situation is one that may not be sustainable, what should you do?

Just as you would fold in a game of poker when the odds are against your favour and raise when the odds are in your favour, investing in times of uncertainty is no different from professional gambling.

It is all about taking the right actions to position yourself accordingly based on the probability of profit and loss.

If you feel that the current economic and market situation is not sustainable and that the probability of a financial crisis is increasing, what you can do is to reduce your overall risk exposure by selling off riskier investments and transferring them to safer asset classes.

If you do that, in the case where you are correct and a financial crisis did happen, you will not suffer the full forces of the investment losses as now, only part of your portfolio is exposed to the riskier asset classes which often falls about 30-50% during a financial crisis.

That is what we call risk management and of course, it is impossible for me to go through the details as to how you should go about navigating your investment operations.

7. Summary

Long story short, while every financial crisis is nurtured and imploded by different factors of their respective times, there are common characteristics, patterns and phases that the economy or market goes through before the eventual financial crisis occurs.

Most financial crisis starts off with extreme optimism and hype caused by an external trigger that pushes the asset prices to unsustainable levels as the market participants become more negligent as the days go by.

As the optimism and hype die down, people will start to come back to their senses and realize that the current asset prices and economic structure are not sustainable. When that happens, people will start to sell off their assets which causes asset prices to drop.

While it is impossible for us to identify with precision, when a financial crisis may occur, it is very much possible to position and prepare ourselves for a potential financial crisis as we identify the signs of a potential financial crisis in making through our analysis.

Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides: