Opportunities for investors amidst stock market crashes

26 Jul 2019

A stock market crash can be defined as a sudden and dramatic decline of stock prices across a significant cross-section of the stock market, resulting in a significant loss of investor wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.

Stock market crashes are a social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives market participants to sell. Generally speaking, crashes usually occur under the following conditions:

  • A prolonged period of rising stock prices and excessive economic optimism,
  • A market where the P/E ratios exceed the long-term averages,
  • Extensive use of margin debt and leverage by market participants.

Other aspects:

  • Wars, especially trade wars in the current context
  • Large-corporation hacks
  • Changes in federal laws and tax regulations
  • Natural disasters in highly economically productive areas

All such aforesaid factors may result in the rise of stock prices for companies directly competing against the affected companies. Falling stock prices cause panic amongst some investors, but fluctuations in the market represent business as usual. Investors who are comfortable with this reality know how to respond to falling prices and how to recognize assets that are good buys when stock prices are dropping.

A key principle of investing is 'Buy low and sell high'. However, the volatility of stock markets makes this difficult. One way to deal with the sharp ups and downs in the stock market is averaging. This entails buying more if the stock falls below the purchase price so that the average holding cost comes down. Averaging works best when a company's fundamentals have not worsened but its stock is not doing well due to poor market sentiments or industry-specific conditions.

Investors must consider three factors for averaging:-

  • The company must have a strong balance sheet, i.e. have low debt and high cash reserves
  • The management should be of good quality
  • The company should have a solid unique selling proposition or USP

Without these, cost averaging will not be fruitful. If one buys into a company which does not have a strong business model, the stock will not make a comeback easily.

We can conclude that the market cannot stay at the bottom forever. So, if a stock you have bought falls lower than the purchase price, do a fundamental check on the company – factors such as balance-sheet strength, valuation, management quality and the core proposition. Study the fundamentals of the sector to see if there is any chance of a re-rating. Look at the past performance of the sector concerned and the company under different difficult scenarios.

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