Lessons From the 2008 Stock Crash, Relevant Now

Three lessons from the 2008 financial crisis, useful now

housing prices relative to median household income
••• Zillow; The Economist

No matter what year it is, the 2008 financial crisis and associated stock market crash has lessons to offer to those willing to learn. The majority of people won't learn, and won't be able to avoid the losses that occur during a crash. That's because it's the majority of people selling that causes the crash in the first place. Only when you separate yourself from the herd (the majority) can you objectively see what is happening and potentially avoid the fall.

Here are three lessons which will help you do that.

History Rhymes

Mark Twain is attributed with saying "History does not repeat itself, but it rhymes." Crashes aren't carbon copies of one another--the circumstances are always a bit different, and therefore hard to see. The reasons behind each crash are the same, but the circumstances are different. In 2000 it was internet stocks, and in 2008 it was real-estate and financials that sent the market lower. The next crash could be fueled by cheap credit, junk bonds or a mania in some new technology.

When looking at history to formulate a hypothesis​ for what could happen in the future, cold hard facts are nice, but won't save you. If you memorized all the stats that caused the housing and stock market collapse in 2008 you'd be very good at spotting housing collapses (due to cheap credit, poor regulation, ​and banks over-leveraging themselves) but it may not help you spot the next crash for which circumstances are different.

As you go through the following three lessons, consider how they could manifest in different ways, across different markets. 

Lesson 1. Euphoria

Leading up to late 2007 and early 2008 there was a lot of euphoria, not so much in the stock market, but in the real-estate market. Euphoria is when people are complacent and feel that nothing can go wrong.

People who could never afford a home were now able to get one, and it seemed like the American Dream was once again alive and well.

To fuel a crash euphoria must occur on a wide scale, where a large portion of the population feels everything will be alright, and many even have the feeling that "a new era" is beginning. This new era type thinking means old risks, which hurt people and their investments before, no longer apply. There is a wide-spread belief that prices will continue to rise.

No matter what the circumstances, all ascending asset prices eventually experience a crash. Spotting euphoria on a wide spread scale alerts you it may be coming sooner rather than later.

Lesson 2. Rampant Speculation

The larger and longer the uptrend, typically the bigger and steeper the crash. The reason is rampant speculation. As prices rise it draws in more and more people. Housing price had been rising in the US uninterrupted since 2000, in terms of housing prices relative to income. Then in 2006, before the stock market crash, housing prices peaked (see attached chart). The long run higher in prices attracted all sorts of speculators and/or people who wouldn't typically consider buying a house.

The same happens in any big run-up before a decline. People pile in because everyone else is doing it. They don't understand the risks..."If everyone else is doing it (and making money), it must be OK." It is this exact thinking which drives prices too high too fast and causes an eventual crash.

A house is a huge investment and is linked to banks and insurance companies which are publicly traded on the stock exchange. As housing prices fell financial stocks were hit especially hard. They were on the other side of the real-estate frenzy; while people who bought houses were assuming debt, the banks were giving it to them. When housing prices fell the houses became worth less than the debt owed on them, and people walked away from their houses. Their good investment was no longer good, and the bank was left with a pile of depreciating assets and loads of issued debt which it couldn't collect on.

The whole stock market followed suit, with the S&P 500 declining 57.6% from its high in 2007.

Lesson 3. (Lack of) Regulatory Oversight

When prices rise, anyone who bought prior is now making money. It's politically unpopular to stop prices from rising and to prevent people from making money. Therefore, regulators are pressured not to stop euphoria fueled rampant speculation.

Laws won't protect you from a stock market crash. New laws and regulations are enacted after every crash, and they have not prevented the next crash.

If you see lots of people who can't afford or know nothing about a particular asset and yet are telling everyone to buy (and are allowed to buy!) you're probably in the buildup to a crash.

The Final Word

Crashes in various assets will continue to occur, and regulation won't stop it. Rampant speculation and rising prices make it politically unpopular for regulators to stop prices from going higher. Rampant speculation is in turn fueled by a feeling of euphoria-- a wide-spread belief that prices will continue to go higher and the economy is in a new era where old risks don't apply. Since each crash looks a bit different, even regulators and traders can get caught off guard; they themselves are not impervious to feeling euphoric and getting swept up in herd behavior which ultimately hurts them.