Observations On The Stock Market Collapse

During the stock market collapse of 2007-2009, it took the DJIA eight months to lose 2,000 points. Yesterday, the Dow quietly lost 250 points, bringing its January losses to 2,000 points—accomplishing in three weeks what it took eight months to do in the last market collapse. In this message, I’d like to look at the forces that cause stock markets to collapse.

For several decades before the previous stock market crash, the government took the view that the “American Dream” of owning a home should be an attainable goal for everyone who had a job. The government encouraged the creation of new lending rules that made it possible for more people to qualify for home loans . The new lending rules needed to allow people with lower incomes to qualify for home loans. One way payments were made more affordable was by offering adjustable rate mortgages with low interest rates and low monthly payments for a few years—and higher interest rates with higher payments later on.

It was a time of fast-paced buying and selling of homes. To fill the increased demand, many new homes were built. Construction, home improvement, and building material companies prospered. The increase in jobs and higher productivity created a strong economy. And the growing housing market brought rapidly escalating home prices.

The Trouble with Bubbles
When the price of something rises quickly, there comes a point where buyers perceive the price as being too high. A price or market bubble exists when buying and selling is done at prices above the actual (intrinsic) value of the item being sold. When buyers leave the market because prices are too high, demand for the item decreases and prices begin to fall. The drop in price is known as a price or market correction. In normal conditions, a price correction takes prices back down to levels that more closely reflect intrinsic value.

The collapse of the housing market between 2007 and 2009 was a case of a deflating price bubble. Homes were being sold at inflated prices until they reached a point where buyers could no longer afford them. When buyers left the housing market, home owners were stuck holding mortgages for properties that were worth less than what they paid for them. When the short term low-interest payments expired and monthly payments went up, many people defaulted on their loans. The wave of defaults created a surplus of homes. The surplus returned home prices to more realistic levels.

The majority of money invested in stock markets comes from financial institutions like banks and insurance companies. Financial markets live and die by the flow of institutional money. The prosperity of the stock market prior to the crash in 2008 was due primarily to an influx of money from the banking industry, which was due largely to the housing boom. Everything seemed to be going smoothly until the economy hit a snag and people began losing their jobs. As unemployment rose and borrowers could no longer afford their mortgage payments, a wave of foreclosures followed. Borrowers defaulted on home loans by the tens of thousands—leaving banks with massive debt loads on their balance sheets. Many banks did not survive due to the burden of bad debt. And as banks failed, the money that supported stock market prices was withdrawn, causing a market collapse.

The stock market crash of 2007-2009 was another example of collapsing market bubble. Stock prices at the time were inflated far above their actual value. The market correction would have taken them down to their intrinsic value, were it not for one thing: When the federal government saw a wave of bank failures coming and a collapsing stock market, it stepped in and provided trillions of dollars of relief, in the form of new money, which it loaned to banks to keep them from failing. The new money allowed banks to continue operating. And as banks always do, they invested the new money in the stock market. The investment of new money prematurely halted the market correction. Stock prices never reached their intrinsic values. Since then the market has boomed, but there is still the problem of inflated stock prices. Eventually, the market must correct itself again and prices must fall to levels that more closely reflect intrinsic values. It could be that the decline we’re seeing now is the restart of a market correction that was halted in 2009.

This is an excerpt from my book A Kingdom View of Economic Collapse.