The stock market is a fickle beast.
One day it’s up; the other it’s down. It can be in a bull trend, or a bear trend – and you won’t really know until after it’s begun.
To top it all off, each day brings volumes of economic and financial data for thousands of companies that work in concert with foreign currency exchange, commodities, options trading, and a plethora of other happenings and goings-on in the world.
It’s no wonder why stock market panic breaks out every now and then.
When this occurs – when investors collectively freeze and then rush to their computers and trading stations to sell, sell, sell, you can take advantage if you understand basic market economics and have the patience to withstand the impulse to act irrationally. Here, I’ll give you information about how you can take advantage of opportunities that emerge whenever the market turns irrational and panics.
What Causes a Stock Market Panic?
If you are a student of American history, you might be familiar with the term ‘panic’ as it was used in the 1800’s. During that time, any moderate to severe economic crisis was called a panic. (Today, we refer to them as recessions or depressions.) A panic was the same then as it is now – a period of economic contraction in which the nation’s economy shrinks.
That isn’t the only factor, though. As you can imagine, the term ‘panic’ suggests that during these crises, people, well, panic. In the stock market, stocks would be sold so that investors could have cash on hand. In the financial system, people would rush to withdraw their money in fear that banks would collapse – which, predictably, led to banks collapsing. Prices generally collapsed, high unemployment ensued, and companies went bankrupt and out of business.
Panics/recessions/depressions cause people – especially investors – to panic. What causes these events to happen?
One main culprit is a bubble. This is when prices for a particular item, product, or service swell quickly and irrationally. This is unsustainable; when prices get too high for the market to bear, the bubble “pops”, which means prices crash and fall dramatically. The real estate crash of 2007 was the end result of a dramatic rise in housing prices from 2000 to 2006.
Supply shock is another cause. This happens when something severely disrupts the supply of a needed or desired good or service. When oil prices were (artificially) inflated dramatically in 1973, causing an energy crisis (and panic), that was an example of a supply shock.
How the Market Reacts
When I use the term “market” here, I am referencing the collective body of buyers and sellers. The market for stocks is very vulnerable to irrational behavior, or behavior that doesn’t have a compelling reason but happens anyways.
In the face of a supply shock, bubble, poor economic forecast, or any other negative event, the natural tendency is to worry. This is understandable; investors have their money and that of their clients at stake, and one’s livelihood can be tied into the performance of the stock market.
When that is threatened, the natural impulse is to protect yourself by cutting risk – which means selling stock and converting your securities into cold, hard cash (or gold, or other precious metal of choice).
When a few investors do this, nothing bad happens other than a pretty mild price decrease. When the market as a whole goes into panic mode, disaster strikes. Remember: a tremendous amount of trading is based on psychology. As such, it is frighteningly easy for fear, worry, and insecurity to spread through a market and cause ripple effects.
One effect is what I call the snowball effect. This is hypothetical, but let’s say that Apple severely misses its targeted quarterly earnings forecast. Investors and analysts may view that as an isolated event…or they may view it as a sign that other companies like Apple are similarly weak. This could result in a sell-off of stocks for these companies – which can then spread through the rest of the industry and sector.
Before you know it, investors are panicking over the tech sector going under – which quickly creates widespread fear so that a general sell-off begins. In what seems like a blink of the eye, the market index drops by hundreds of points and a full-scale panic has set in.
Note: It doesn’t always happen like this, and sometimes very real economic concerns emerge to cause fear. That doesn’t make how investors behave any less rational, at times.
What Can You Do?
If you are a sound investor- meaning you have thoroughly analyzed your companies before buying their stock, keep track of economic events and trends, and have set reasonable price goals as well as stop-loss levels of 1%, 2%, 5%, or whatever percentage of your capital that you choose – you can take advantage.
What is one gigantic opportunity that always happens when the market panics and goes south? This: the chance to buy solid stocks for bargain-level prices.
Remember, panics are inherently irrational. They drag down a lot of companies that are sound and on solid financial ground, with good growth prospects and steady income – you know, companies that in a normal market are doing very well.
Case in point: The market most recently crashed in 2008 and lost over half its value within 18 months. Investors who didn’t set loss levels – and subsequently loss most, if not all, of their money – were hit hard.
Investors who set loss levels and were patient were able to buy near the bottom and pick up a lot of really good stocks for cheap. For example, there are few companies stronger than Google. Before the market went south, on August 15, 2008, GOOG was valued at 510.15 per share. It lost a tremendous amount of value and on November 21, 2008 it closed at 262.43 – a reduction of 49%.
GOOG closed on July 27, 2012 at 634.96 – an increase of 140% from its low and an increase of 24% from its previous high that August before the crash.
That is just one example of how investors who are patient and prudent – and willing to make a move – can snap up great stocks at fire-sale prices.
That, in essence, is what you can do when a panic sets in. If you are even more adventurous (and experienced) you can make money on the downswing by short-selling stocks or index funds. Unless you’re a seasoned investor, though, and have a firm grasp of macroeconomic analysis, leave that process alone.
Either way, stock market panic gives you opportunities to profit as long as you keep your head while everyone else loses theirs.
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