2008 Financial Crisis and Stock Crash, Causes and Lessons
Trade your favourite markets with our top-rated broker,. 10/10
77% of retail CFD accounts lose money.
The 2008 financial crisis resulted from a buildup of financial problems during 2003 to 2007, all while the US stock market moved higher. Starting in 2007 and then throughout 2008 the stock market collapsed under fears of a financial system meltdown. Many US banks went bankrupt or required government bailouts. The 2008 financial crisis was the worst since the Great Depression of the 1930’s.
The S&P 500 index peaked at 1576.09 in October of 2007, and traded as low as 1411.19 at the end 2007.
2008 commenced with more selling, and any short-term rallies remained well below the prior peak. The selling continued, with the largest declines occurring in September and October of 2008. The S&P index ultimately reached a low of 666.79 in early 2009, a 57.7% decline from the high. The sell-off lasted 1 year and 4 months.
An uptrend followed, eclipsing the old high of 1576.09 in April of 2013. In other words, it took 5.5 years for the stock market to fully recover the losses experienced during the crash. While this is devastating for those who held onto stock throughout the decline. Those that bought stocks in early 2009 saw stock prices rise by 70% over the next year, and nearly 100% over the next two years. Between 2009 and early 2018, the market had rallied more than 320% off the low.
Reasons For the 2008 Financial CrisisCopy link to section
The US stock market collapse was tied to the collapse of major financial institutions, including Lehman Brothers and the government bailout of AIG (so it wouldn’t collapse). Financial institutions were in trouble because of over-exposure to declining housing prices.
Financial products were created to package mortgages. These packaged mortgages were then sold to other financial institutions. The idea was that you could offer a mortgage to someone who could barely afford it (high risk), but offset the risk by packaging this junk loan with higher quality ones. This generated lots of fees and commissions for the banks, and was fine…as long as housing prices continued to rise.
When housing prices started to fall, those who couldn’t afford their mortgages in the first place were forced to sell, pushinghousing prices down. This triggered even those who could afford their mortgages to sell. Why? Because as housing prices fell the amount owed on the mortgage was greater than the value of the house.
Anyone who bought expecting to make money off their housing investment was now facing the likely possibility that they wouldn’t. Also, when a mortgage is bigger than what the house is worth, the bank may make a cash call on the homeowner to make up the difference between what is owed and the value of the home. Most people don’t have tens of thousands of dollars lying around, nor is there incentive to pay up when housing prices are dropping quickly. Many people opted to walk away from their homes, or where forced by financial circumstance, leaving the bank to sell it.
With banks under severe pressure and facing mass amounts of mortgage defaults, bank stocks were sold off. Because the banks were in a tough financial position they stopped lending out as much money, both at a retail and institutional level. Without access to credit, many normal companies found it hard to operate. Panic set in and investors sold off stocks and real estate holdings, leading to one of the biggest crashes in modern history.
The housing market isn’t the stock market, but it is linked. When a lot of people are facing real estate losses, or are getting a call from the bank to cough up more money to cover the declining value of the home, those people are likely to sell other assets like stocks.
The inability to access credit, or having credit cut off, also meant that anyone who purchased stocks on credit/margin was unable to hold onto their positions as prices started to drop. This creates a domino effect of selling. It doesn’t matter if the person believes the stock market (or housing) will eventually go back up. In that moment many people can’t afford not to sell.
Lessons From the 2008 Stock CrashCopy link to section
Similar to the 1929 crash and 2000 crash, it takes years for stocks to fully recover from a major meltdown. On the flip side, for those who have the resources to buy when prices start to recover after a crash, there are sizable gains to be had.
The stock market started to recover even amidst massive bank failures. The stock market is a leading indicator; it started falling before the vast number of bank failures occurred, and started rallying while the outlook was still grim from an economic and fundamental perspective. For example, bank failures continued to escalate into 2010, well after the early 2009 stock market bottom.
When the stock market topped there were very few bank failures, even though the problem was there and brewing. Most people viewed the outlook as rosy at the top, which is why they were willing to keep buying stocks at higher and higher prices…because they believed prices would keep going up. Looking at the economic indicators will often lead people to the wrong conclusion at major turning points. People are most optimistic at market tops, and the most pessimistic at market bottoms. The opposite of what they should be.
Another lesson is that crashes occur with regularity. While the narrative changes each time, the tendency doesn’t. People get euphoric and push prices too high, and then price correct to bargain levels and the cycle repeats. The people who make the big money are optimistic when stock prices are trading at a bargain, and are willing to sell when prices are inflated and start to drop. One way to assess value is to look at stock prices relative to earnings (P/E). It isn’t a perfect indicator, but it does provide some context for whether stocks as a whole are inflated or at bargain levels.
Even holding if holding a big basket of blue chips stock in the portfolio, when a crash happens nearly everything falls. The 57.7% decline in the S&P 500 means that the average stock price loss of the 500 largest and most profitable companies in the US was 57.7%. Holding riskier or less profitable companies meant losses could have been bigger. The point is, anything can fall.
With that said, the stock market also has a long-term upward bias. As it should, because profitable companies will continue to adjust the prices of their products or services for inflation, meaning profits should increase over time. For long-term investors, buying after a crash, or even during, is a major wealth building event.
For some additional insights, here’s a list of movies and documentaries on the 2008 financial crisis:
The Big Short (2015)
99 Homes (2014)
Inside Job (2010)
Too Big to Fail (2011)
The Flaw (2010)
The Last Day of Lehman Brothers (2009)
Margin Call (2011)
Invezz is a place where people can find reliable, unbiased information about finance, trading, and investing – but we do not offer financial advice and users should always carry out their own research. The assets covered on this website, including stocks, cryptocurrencies, and commodities can be highly volatile and new investors often lose money. Success in the financial markets is not guaranteed, and users should never invest more than they can afford to lose. You should consider your own personal circumstances and take the time to explore all your options before making any investment. Read our risk disclaimer >