What's Causing This Crash?

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Make no mistake about it, when we look back at what's happened over the past 10 days, we'll refer to it as the "Crash of 2008," putting it in the same category as the infamous plunges of 1929 and 1987.

As I write, since the end of September, the Dow has tanked some 24%. Shares of General Motors (NYSE: GM  ) have been cut in half in the past month. Goldman Sachs (NYSE: GS  ) is down 33% this week alone. Even cash-rich companies that have absolutely nothing to do with the credit crunch are getting killed: Microsoft (Nasdaq: MSFT  ) is off 20% this week, Google (Nasdaq: GOOG  ) is off about 17% in the same timeframe. All as I put fingers to keyboard. Perhaps the biggest irony of all is that the only stocks that seem to be showing green this morning are banks, with Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Citigroup (NYSE: C  ) all gaining ground.

It's a mess, that much is clear. But why? What did I miss that's pummeling stocks day after day on what seems to be no news at all?

Panic. Pure, gut-wrenching panic.
It really is about as simple as that: People are panicking. You'll be hard pressed to find someone who can look you in the eye and tell you they've crunched the numbers and concluded stocks are worth 24% less than they were 10 days ago.

The wave of selling we've seen over the past week has little to do with fundamentals and a lot to do with investors wanting to be in nothing but the safest-of-safe instruments, namely cash and gold. In the past week alone, investors yanked some $52 billion out of mutual funds -- on top of the $72 billion pulled out in September. Of course, the managers of those mutual funds have to come up with the cash for their investors, and the only way to do that is to sell stocks and bonds, oftentimes indiscriminately.

Then there are hedge funds. As anxious clients around the globe witness the never-ending sell-off, they want to yank their money out, so hedge funds -- which control trillions of dollars and are coming off their worst month in a decade -- are scrambling to sell whatever they can to cover client redemptions.

It's the leverage, stupid
Couple that with the fact that so many hedge funds employ leverage -- meaning they borrow money to invest with -- and those borrowed funds can be subject to "margin calls," where the banks that lent the money demand more cash as the hedge funds' stock collateral falls in value. Connect the dots, and you get a situation where falling stocks triggers margin calls, which calls for selling, which triggers more margin calls ... you get the idea. What's important is that this type of activity is forced selling, not selling because money managers think stocks are necessarily overvalued and awaiting a fall.

When markets are leveraged and fear is in the driver's seat, you get a situation where selling begets selling, fear begets fear, and stocks just can't seem to find a bottom. That's exactly where we are today.

Credit, credit, credit
If there is one bit of justification to the recent swoon, it's that credit markets have all but ceased to exist. If credit markets stay choked up for a long time, it's nearly impossible to predict a company's future earnings, and if you can't predict their earnings, markets turn into a multitrillion-dollar guessing game.

Regardless, the important thing to know is that the levels stocks are trading at have become completely detached from the fundamentals that drive their long-term value. Sure, credit markets are in the tank, but that will eventually subside, we just don't know when.

If you think the world will still be around in five years, there's a good chance you'll look back at times like today as a once-in-a-lifetime buying opportunity. That's not to say stocks won't continue their cliff-dive from here, but long term, there's little explanation for why the Dow is trading where it was over a decade ago.

Relax. Take a deep breath. We'll make it through this mess, Fools.

For related Foolishness:

JPMorgan Chase and Bank of America are Income Investor selections. Microsoft is an Inside Value pick. Google is a Rule Breakers recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 10, 2008, at 5:01 PM, Brettze wrote:

    This crash is caused by Wall Street who assumes that all of us would accept what is offered to us.. No,, we are not zombies no more.. We are learning how to change ... Wall Street thought we are gonna be hyponitized !

  • Report this Comment On October 10, 2008, at 9:54 PM, karangankedah wrote:

    The simple basic truth is that Americans as a whole have been living beyond their means and taking everything for granted. However pride always get in the way. the bigger the myth, the bigger the pride. America no longer needs (nor can it afford) its huge military complex. American politicians just have to be better human beings, like the decent American people they claim to represent.

  • Report this Comment On October 10, 2008, at 9:59 PM, cosmos42 wrote:

    Today, I opened my electronic trading account 5 minutes before the opening bell and watched in amazement as my IRA portfolio lost $10,000 in 7 minutes and the Dow lost 700 points. Wow!

    In 1987 there was one major rubber band that snapped and the markets crashed. Back then I had to call my broker and if I could contact him, I would SELL. That was like snail mail. Today with a keystroke I can sell thousands of shares and turn over thousands of dollars. Take the millions of investors who have fear and panic because their retirement was just halved in the past couple of months and there are a lot of indiscriminate keystrokes going on. I think we now have seen the potential impact of the common investor.

  • Report this Comment On October 11, 2008, at 7:04 PM, SteveTheInvestor wrote:

    Thus the need to slap some serious regulations on both the use of leverage and off balance sheet assets. Not to mention the need to require that credit be given only to the credit worthy. This whole situation could have been avoided if some reasonable practices had been in place.

    I've been gradually moving to cash since last year but even so I'm down 20% and I feel like an idiot. Should have gone 100%. Next time I'll listen to me instead of the Pollyannas.

  • Report this Comment On October 11, 2008, at 8:01 PM, notehound wrote:

    WARREN BUFFET has called the $55 Trillion in outstanding credit default swaps (CDS) “financial weapons of mass destruction.” These agreements among banks and companies were intended to shield them from the risks created by mortgage-backed securities, corporate bond defaults and other financial disasters. The CDS instruments with Lehman Bros. as a counterparty became virtually worthless when Lehman filed bankruptcy. Same issue came up in the AIG nationalization. This threw the world banks into a lockdown where no bank would trust anyone to repay money loaned. They are waiting to see which of their other counterparties (banks, brokers, companies or insurers) defaults or files bankruptcy. The credit and stock markets have reacted accordingly.

    HERE’S THE CORRECT WAY TO HANDLE CDS SYSTEMIC RISK, from a former bankruptcy attorney as well as former General Counsel to a Mortgage-Backed Securities Issuer:

    Markets will not resume rational behavior until the nuclear threat of credit default swaps has been rendered harmless. There are $55 Trillion of these private, non-regulated insurance agreements outstanding involving every major money center bank, investment house and major insurer worldwide.

    There are two ways to take away counterparty risk. One is to guaranty their performance. The other is to render them unenforceable or of only limited enforceability.

    Systemic confidence in world banks is so low that a government guaranty of counterparty obligations is totally worthless. Once everything has been guaranteed, nothing is guaranteed.

    As a matter of public policy, the risk of enforcement of credit default swaps would be much more destructive to world economies than would be the risk of their unenforcement. These instruments were an unregulated, and unsanctioned, form of insurance. These instruments must be taken out of the equation in order to return the world banking system to the status quo ante.

    The G7 meeting should result in a unified announcement that none of the currently outstanding credit default swaps will be enforceable in any of the G7 nations’ courts for at least five years as a matter of public policy. A G20 announcement could follow. A Derivatives Court of Claims could then be set up at the Hague to review such instruments, submitted by the parties and counterparties.

    The Court of Claims could then act as a Court in equity to determine the putative obligations and cross-obligations of the parties, with a decision as to what percentage of the obligations should be enforceable, if any.

    This would be, in effect, a bankruptcy court for an entire shadow insurance system, if you please.

    Remove the CDS Sword of Damocles by declaration of unenforceability. Then, banks could begin lending to one another again without worthless guarantees from each other or from governments who are already on the hook for systemic risk.

  • Report this Comment On October 12, 2008, at 8:34 PM, fc3worships wrote:

    That last comment was the longest comment in the history of life lol

  • Report this Comment On October 13, 2008, at 4:08 AM, vballboy wrote:

    Federal regulators should have never bowed to political pressure asking for "more home ownership regardless of the cost" in the ealry 1990's. Subprime lending fueled a ridiculous housing boom, now a huge bust, and it also allowed people who did not make enough money to cover a mortgage for a $400,000+ house to buy one..and then get stuck after the short ARM-ish subprime period ended.

    Get the fincancial industry lending again, but with better rules. Free market economics causes more problems than it offers improvements. Some good regulation is NO SUBPRIME!

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