The recent stock market crash has delivered a devastating blow to millions of people and thousands of companies around the world. Understanding what caused it is vital to correcting policies that helped create the problem and to insulating your portfolio from crashes in the future.
The 2008 stock market crash had certain similarities to other famous Wall Street debacles, such as the crash of 1929, the bear market of 1973-74 and the Y2K boom and bust. Each was preceded by a steep escalation in equity prices, often to multiples far in excess of underlying business value, only to then fall back down rapidly and dramatically. Each had witnessed large-scale speculation when prices were at their highest, and each has now significantly reduced, and in some cases destroyed, the wealth of speculators, investors and small shareholders. The 2008 crash was slightly different, however, in that the primary trigger of the large sell-off came from depreciating house prices. This depreciation, in turn, caused many people to default on their mortgages. These mortgages, which had been bundled up into instruments such as collateralized debt obligations, then rapidly lost value, which brought down numerous investment houses that had invested too heavily in them, creating a crisis of confidence in the whole financial system.
Significance and Effect
The stock market crash has been significant for a variety of reasons, the most prominent among them being wealth destruction. Estimates vary on exactly how much individuals and companies lost, but most figures are in the ballpark of tens of trillions. These losses have not only been catastrophic in their own right, but by reducing the value of collateral holdings and investments, they've created a condition of increased risk and higher borrowing costs for businesses, which will in all likelihood negatively affect their profit margins and ability to hire and retain employees for years to come.
Although accounts of what led to the stock market crash vary, many commentators have focused upon the decision of the Federal Reserve to keep interest rates artificially low for a prolonged period of time as a primary factor in fueling speculative excess in both housing and stock markets, along with grossly poor investment by a variety of businesses. This excess, coupled with poor lending standards and the mortgage securitization conducted by large investment banks and government, supported enterprises such as Fannie Mae and Freddie Mac, led to a systemic crisis in the financial system, causing investors to sell their shares en masse to avoid further losses and margin calls. Some have suggested that since the Federal Reserve was a primary cause of the crises, it should be disbanded or at least have its activities greatly curtailed. Lending standards should also become more rigorous and pseudo-governmental agencies such as Fannie Mae and Freddie Mac should stop interfering in, and thereby distorting, the housing market. Still others have called for a complete overhaul of U.S. and international accounting standards, as they feel the old models were abused by companies to inflate their profits and hide their losses, duping ratings agencies, government regulators and investors.
The size and scope of the stock market crash was massive, and spanned the entire globe. Due to the interconnectedness of the global economy, and the ubiquity of instruments like Collateralized Debt Obligations, almost every developed nation in the world has experienced the loss of billions of dollars as a result of the crash, and now faces a very tough journey back towards economic growth.
Although stock prices have fallen a long way from pre-crash levels, some financial commentators have suggested the overall stock market is still overvalued and could decline further. A useful tool for determining the overall valuation of the stock market is to use the trailing price-to-earnings average of the S&P 500, which is calculated by dividing the price of the S&P by the earnings per share of its component companies. Fair value is a price-to-earnings multiple of about 15. A multiple of 10 is undervalued, and 20 is overvalued. Valuation levels are still close to 20, in spite of the large scale stock sell off, so stock prices might still fall further before offering attractive prices for investment.