Our last blog discussed the indicators of a potential market melt up which included an economic upturn, an increase in consumer spending and increased demand for investment products that promise high returns. We concluded that share prices rise rapidly in a melt up. A market meltdown is an opposite side of the spectrum to a melt up where share prices decline rapidly.
Market meltdowns are one of the most talked about events in the history of the stock markets; those who lived through them remember the crashes in 1929, 2000 and 2008.
These are the key factors that lead to a meltdown:
- The market is at a high, employment rates are high, and wages rise, meaning people have money to spend.
- Low interest rates, which create opportunities to borrow money to purchase property and high-end consumer goods.
- Cash is available to invest in shares and other market instruments.
- With the positive outlook and the ongoing increase in income, loans and credit are extended, and many consumers spend their future earnings.
- These conditions create the likelihood of increased inflation.
- Central banks begin to raise interest rates to dampen an overheating economy and quell inflation.
- Higher interest rates lead to increased costs of servicing new debts resulting in decreased disposable income.
- Spending and investing begin to slow.
- Many consumers are forced to sell assets to reduce debt
- Increased selling causes prices to fall, and with more sellers in the market than buyers, prices begin to fall further.
- The price declines are exacerbated if assets were bought at inflated prices and speculators look en masse to sell. The most speculative assets tend to experience the most dramatic declines.
Sometimes this decline can be less than 20% and it is considered a market correction, bringing prices more in line with the value of the assets. Crashes are more extreme than corrections and can lead to bear markets characterised by sustained declines in share prices.
Investopedia defines a market meltdown or crash as:
Applying our investment philosophy in a meltdown
With a constant focus on buying companies that own great brands that are loved and used by people around the world every day, we only buy shares in companies with low debt to equity ratios and strong cash flows.
When the markets meltdown, we buy more shares in these companies at a low price relative to the cash flows that they generate. These types of businesses also pay regular and increasing dividends to their shareholders allowing shareholders to derive an increasing income while share prices decline. We never intend to sell while the cash flows remain in place.
If you want to know more about this thinking, have a look at some of our other blogs that give tips on how to handle market declines, stay in control of your emotions and enjoy happy hour on the stock market.
At AXIAM, we have spent many years growing wealth with an investment strategy inspired by the wisdom of great investors like Warren Buffett. We buy shares in companies that pay regular, increasing dividends own great brands that are known, loved and used around the world daily and we keep them for a long time. Sign up for our newsletter, or contact our fund management team to invest.