The same rules also apply to the stock market, though the inevitable sometimes takes a little longer to occur. Whether stock prices rise for a few months or a few years straight, they always come down - and the higher they rise, the harder they fall. Gravity, you see, makes no exceptions, not even for Wall Street.
The best-known example of a market crash occurred in 1929. On October 29, a day remembered throughout history as "Black Tuesday," the New York Stock Exchange (NYSE) lost one-third of its entire value and dumped 16 million shares. More money was lost during that one day than ever before - stocks hit rock-bottom and thousands were financially wiped out.
After the stock market crashed in '29, many theories surfaced to try and explain it. I spent a few days in New York reading up on some of them, talking to experts and visiting the NYSE itself. One thing I learned is that buying on margins was a really bad thing. Let me explain:
The thing is, stock prices are supposed to reflect a company's overall performance. If Nike announces that sales were up by 30% in the last quarter, then its shares will rise because people will feel good about Nike. But if Dell Computers misses its projected profit goal, then its shares will fall for the opposite reason. Thus, performance indicators are (for the most part) the reason stocks go up and down.
Back in 1929, however, stocks were going up because more and more people put money into the market, not because companies were necessarily doing well. All this speculation led to a rapid increase in the prices of stocks (they rose about 250% in the previous five years before 1929) and many analysts began to warn of an impeding "correction." (A correction means the market readjusts its prices to what they really should be).
Although some government officials knew what was about to happen, nobody did anything. In fact, by late March '29, the Federal Reserve was meeting behind closed doors everyday to try and come up with a solution, but there was none.
On Thursday, October 24, 1929, the bottom began to fall out. Prices dropped as investors tried to sell off their holdings. By the end of the day, the NYSE had lost $4 billion. On Monday, full-blown panic set in and then on "Black Tuesday," prices fell so much as to wipe out all the gains that had been made in the previous year. Between October 29 and November 13 (when stock prices hit their lowest point), over $30 billion disappeared from the economy.
When panic hits, it's all over. Panic, according to Webster's Dictionary, is a state of sudden, overpowering fright; a sudden unreasoning terror accompanied by mass flight; or a sudden widespread fright concerning financial affairs. Notice how many times the word "sudden" comes up - that's because when there's a panic, it's immediate. Investors didn't stop to think about the possibility that the market would bounce back. They didn't want to wait and see what happened the next day. All they wanted was to sell their stocks and cut their losses.
The volume of trade on "Black Tuesday" was so enormous that the ticker tape machine couldn't keep up. Investors panicked even more when they couldn't figure out the exact stock prices, which in turn generated more sales, which slowed down the ticker tape even more! Aaahhh - what a mess!
It got worse. Speculative banks (the ones that lent money to investors) collapsed with the market, setting off a panic-driven "run" on the banking system. Customers feared that if they didn't withdraw all their money, they would lose it if their banks were to fail. Well, when they withdrew all their money, guess what happened? The banks failed - 4,000 in all!
It took many years to clean up the fall-out of the crash. Public confidence in the economy plummeted and the government realized that in order to restore faith, it needed to set some regulations. In 1934, the government created the Securities and Exchange Commission (SEC). The role of the SEC is to make sure that all companies selling shares disclose meaningful financial and other information to the public.
One man, a "member" (person who can buy and sell stocks in the exchange) of the NYSE whom I caught off-guard during his cigarette break, said that in 1929 the banking system had no rules and was very unprepared to deal with problems. He explained that the Federal Reserve is now much more involved in the market, often "pulling the reigns" if it's moving too fast or "cutting some slack" if it needs a little kick in the butt (by adjusting interest rates). Since he's been in the business for 41 years, I guess he knows what he's talking about!
Still, not even he could offer a prediction of what the market will do next. When I asked him for a thumbs-up or down, he shook his head and shrugged his shoulders. When I asked him if the crash of '29 could conceivably occur again, he mumbled a few words - "Well, maybe…er…I mean, look…uhm…probably not, but who knows? - and bid me a hasty farewell. Like a weatherman, the most he can do is spread his bets and hope to avoid the occasional storm. The risks he takes are high, but so are the rewards. As we all know, nothing is more tempting than the possibility of making a quick buck.
The lessons from '29 are many, but if you can remember only one, make it this: if you don't want to get wet, stay inside.
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Rebecca - Burn that book! It's on the best-seller list