Amidst all the gloom and doom associated with a market crash, let’s put emotions aside and just look at what a crash actually means. The ‘experts’ on the mainstream media (I call them the lamestream media) like to cheer bull markets and talk about market crashes in a sombre tone, as if they were talking about someone’s funeral. It’s an attitude which suits them well for a career in the dying news business, but not one which we as investors can actually profit from.
Which brings us back to the question: what exactly is a market crash?
A market crash is a period when valuations of most financial assets are falling rapidly.
During a market crash, the valuations investors place on assets change. There is more fear in the market. Inventory is liquidated. The proximal causes can be anything; the ultimate cause is the manipulation of interest rates by central banks (a topic for another day). Looked at this way, there really is nothing special about a market crash.
Imagine walking into a mall and passing by a Levis outlet with a 50% off sale sign. You’ve always wanted their signature blue jeans and now is as good a time as any to buy it. With the money you’ve saved, you walk into The Body Shop, where they have a 70% off sale, and get your fill on your personal care products. You go home a happy customer, eager to try out your new purchases.
The same principle applies to the financial markets. Holders of inventory are marking down their assets in a huge, huge sales orgy. You can shop till you drop, buying quality assets you could have ill afforded at the full price quoted earlier. Unlike jeans and body wash, these can later be sold effortlessly by issuing a sell order through your brokerage account once the discount season ends and prices return to normal.
A stock is a part ownership of a business. It is a claim on capital and on the future cash flows generated by that capital. The capital is not destroyed when a stock price goes down. Even if the sellers of stocks take losses, the capital is still owned by someone. That buyer is a more capable holder of capital than the seller, at that price. He owns it because he values the capital more than the seller. The net effect is that in a stock market crash, ownership of capital is transferred from less capable owners to more capable owners – which is precisely what one should love to see. Capital is deployed best by those most competent to own it.
Some businesses declare bankruptcy and liquidate assets during the crash. Here, the losses are realised by those who owned the business – the ones who took a direct equity stake and the ones who lent it money. If the loan had been made against collateral, then that collateral can be sold to make the lenders whole. If the loan value is greater than the then market value of the collateral, then the lenders have lost money to the extent they erred in their judgement of its market value. If there’s enough money left on liquidation to make lenders whole and then some, the equity investors get some money back too. In this entire scenario, it is only the valuation of the claims on the business (debt and equity capital) that has changed. The assets are still there. When they are sold, the assets are once again moved from less capable owners to more capable owners, at that price.
In summary, in a market crash, the total capital stock of an economy remains intact. Only the valuations of the claims on the capital stock change, and ownership of capital is transferred from less capable owners to more capable owners.
Crisis = Opportunity
This is the time to pick up undervalued assets when they enter the deep discount rack. It’s the shopping season of the decade, and one to be as eagerly awaited as Thanksgiving and Christmas. So gear up and get in line, it’s time to do some serious shopping!