🫧 Bubbles and crashes: what market history teaches a trader

🎯 In 30 seconds: Market history repeats in patterns, not in details. Bubbles grow when a true story (a new technology, a booming economy) meets easy money and the belief that prices can only go up. Crashes come when borrowed money has to be repaid, buyers vanish, or the story stops being believed. Some recoveries take months; some take decades; some single stocks never come back. The practical lessons are few and boring: borrowed money shortens your margin for error, liquidity disappears exactly when you need it, a great company can be a bad investment at the wrong price, and you should size every position assuming you might be wrong.

What a bubble is, and why it is hard to see from inside

A bubble is a period when prices rise far beyond what the underlying cash flows can reasonably support, driven mainly by the expectation that someone will pay more later. A crash is a sudden, deep fall, often in days or weeks.

Bubbles are easy to name afterward and hard to call in real time. During one, rising prices seem to confirm the story, people who stayed out look foolish, and doubters are often early by years. That is why this chapter is not about predicting the top. It is about the habits that let you survive whichever way history turns.

Bull and bear markets already has a table of the big US declines from 1929 to 2022 and how long each took to recover. This chapter goes wider: other countries, single events, and the mechanics behind them.

Five episodes, five mechanisms

1929: when the margin calls came

In the 1920s, new brokerage houses and margin accounts let ordinary people buy stock with borrowed money. According to the Federal Reserve's history of the crash, buyers typically put down about 10% of the price and borrowed the rest, with the stock as collateral. The Dow rose about six-fold from August 1921 to September 1929.

With 10% down, a 10% fall in price wipes out the buyer's entire stake. Lenders then demand more money or sell the stock, which pushes prices lower, which triggers more calls. On Black Monday, October 28, 1929, the Dow fell nearly 13%, and almost 12% more the next day. It went on to lose 89% by the summer of 1932 and did not regain its 1929 high until November 1954.

Today's US rules require far more than 10% down for most stock purchases on margin. The mechanism still works the same way at any level of borrowing. Margin explained walks through a modern margin call.

Leverage in one table

Leverage means controlling more assets than your own money, using borrowed funds. The question that matters: how far can the assets fall before your own money is gone? The answer is 1 divided by the leverage.

Japan, 1989: a generation underwater

At the end of the 1980s, Japan's economy was booming and its stock and property prices soared. The Nikkei 225 index set a record close of 38,915.87 on December 29, 1989. Then the bubble burst. The index did not close above that level again until February 22, 2024, more than 34 years later.

The lesson for a US investor is not "Japan is different". It is that a broad, diversified index of a rich country's best companies can take a working lifetime to recover when it starts from a bubble price. Diversifying across countries and buying over time, rather than all at once at a peak, are the usual defenses. A plan for a young person shows how regular investing spreads out your entry prices.

LTCM, 1998: brilliant people, borrowed money

Long-Term Capital Management was a hedge fund run by star traders and two Nobel prize winners in economics. It bet on small price gaps between similar securities closing, trades that each earned little, so it borrowed heavily to make the returns large. The Federal Reserve's history says it held about $30 of debt for every $1 of capital at the end of 1997, and it earned 20% to 43% a year from 1994 to 1996.

In 1998, after Russia devalued its currency and stopped paying some debts, investors fled to safety and the gaps LTCM bet on widened instead of closing. The fund lost 44% of its value in August alone. In September, fourteen banks and brokers put in $3.625 billion to take over the fund and wind it down in an orderly way, in a deal the New York Fed helped arrange without lending its own money.

The lesson: a strategy that "almost always" works can still ruin you if it is sized so that one bad month is fatal. Being right in the long run does not help if you cannot survive until then. Risk comes first puts numbers on this.

The dot-com bust: right story, wrong price

In the late 1990s, investors correctly saw that the internet would change how people shop, talk and work. They priced it as if almost every internet company would be a winner. The Nasdaq Composite closed at a record 5,048.62 on March 10, 2000, then lost roughly three quarters of its value by late 2002. It took 15 years, until April 23, 2015, to close above that record.

Worked example: $10,000 put into the index at the March 2000 close and down about 78% at the 2002 low would have been worth about $2,200. To get back to $10,000 from there takes a gain of $7,800 / $2,200 = about 355%. Many individual internet companies never recovered at all; they went bankrupt or were bought for scraps. The index survived because winners grew and losers were replaced. Your portfolio of five favorite names would not have had that protection.

2010 and 2021: when the plumbing and the crowd take over

May 6, 2010, the flash crash. On an already nervous afternoon, the joint SEC and CFTC staff report found that major US stock indexes, already down more than 4% for the day, fell another 5% to 6% in a matter of minutes and then rebounded almost as quickly. More than 20,000 trades in over 300 securities were executed at prices more than 60% away from where they had been moments before, some at a penny and some at $100,000. The report traced the start to a large automated sell program in stock index futures that fed orders in without regard to price or time, while buyers pulled back. The market ended the day down about 3%. Rules such as the limit up-limit down bands in The rules every trader runs into came out of that day.

January 2021, the meme squeeze. A video game retailer's stock, heavily sold short and heavily discussed on social media, closed at $347.51 on January 27, 2021. The SEC staff's report on the episode notes it had closed at about $20 two weeks earlier and touched $483 the next day. From its January 8 intraday low to the January 28 high it rose about 2,700%, then fell more than 86% by the close at the end of the first week of February. People who bought near the top on the story lost most of their money within days.

The shared lesson: in fast markets, the price you see is not a price you can count on getting. Market orders, tight stops and margin all get worse when liquidity disappears. See Order types in depth and Short selling for the squeeze side.

The lessons, as habits

1. Size for being wrong. Decide in advance how much of your account any single idea can cost you. Position sizing has the formula.
2. Treat borrowed money as a shorter fuse, not a bigger engine. Use the leverage table above before using margin or leveraged funds.
3. Expect liquidity to vanish when you need it. Use limit orders. Avoid holding thin stocks you would need to sell in a hurry.
4. Separate the story from the price. Write down what you are paying per dollar of earnings or sales, and what would have to happen to justify it.
5. Diversify across what can fail together. Different companies in one hot theme are one bet. Different countries and asset types are several.
6. Plan for long recoveries. If you could not live with a 10-year wait on a position, it is too big or too concentrated.

Try it

Pick one theme that is popular right now. In the Screener, list five stocks tied to it and note each one's price-to-sales ratio and how far it has risen over the past year. Then use the Backtest tool on one of them with a simple trend rule, and look at the worst drawdown it produced. Ask: if this fell 75% like the Nasdaq after 2000, how much of my account would that cost at the size I was planning? Adjust the size until the answer is one you could live with.

Sources

• Federal Reserve History: Stock Market Crash of 1929
• Federal Reserve History: Near Failure of Long-Term Capital Management
• SEC and CFTC staff: Findings Regarding the Market Events of May 6, 2010
• SEC staff: Report on Equity and Options Market Structure Conditions in Early 2021
• Associated Press via Quartz: Japan's Nikkei breaks its 1989 record (February 2024)
• Associated Press via KTVU: Nasdaq sets record high, 15 years after dot-com bubble (April 2015)