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Why stock exchange crashes?

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Saturday, September 23, 2006

Why stock exchange crashes? This is a very popular question and associated with some painful memories for those who lost a lot in these crashes.

As any other mysterious phenomena, people try to find reasons and causes, and usually they create reasons that are based on fictions more than facts.
I will start explaining my point of view of why stock exchange crash from the most famous ratio in the accounting and company evaluating world "P/E ratio".

What is P/E ratio? P stands for the current market price of a certain share; E stands for the earnings per that share, when you talk Annual P/E that means you are using the last annual earnings per share reported by the company. Of course this number should be audited by some other specialist company or it will be doubtful.

I will list here some example of real P/E ratio:
EBAY: 22/Sep/2006
Last Trade: 26.11
EPS (Earning per Share) (ttm): 0.73
P/E (ttm): 35.96

In the case of Ebay share, P/E according to the last trade on 22/Sep was 35.96.
What does P/E mean for an investment decision?
Suppose you bought eBay share at a price of 26.11, then suppose that the earnings reported by the company last year, 0.73 per share, IS NOT GOING TO CHANGE, in other words the company will make same profit over the next 100 years, this means that you will need 26.11 / 0.73 = 35.96 = 36 years to get back your investment, in other words, your break-even point will be after 36 years!

Of course, no one will put his money in such investment, but still we see people buying and selling the share at this price and even higher, so what is the point here? They keep trading because they know that companies' profits are not fixed, and they are going to change up or down, so eBay earnings per share might get doubled in the next year, and my break-even point will become noticeably closer, and if some analysts could assure that the expected eBay growth in the next few years might double its earnings several times, I would go and buy quickly, knowing that my break-even point could be decreased to 5 years or less which will make it very good investment.

So I buy, not based on the current reported profits, but based on the expectations of the future profits, in other words I'm buying at a price that is considered "over-valued" in the point of view the last annual profits, but might be considered very cheap in the point of view of the realized profits over the next year.
So I'm betting on the company's profits and buy its shares at over-valued prices which is the key-point here to understand why stock exchange crashes.

When the country's economy is growing rapidly, this will reflect on the companies profits, and accordingly on its shares prices in the stock exchange. While the growth is making confident steps, we will see profits doubling every year, we will see people go in and buy shares at high P/E ratios, and sell it at even higher P/E ratios and making good profits.

This is fine, but it is a cycle, and any national economy will start slowing down at a certain peak, and the profits will stop doubling from a year to year, as people used to see it. But most traders, who knows nothing about stock exchange except they are buying and selling and making good profits for several years, most of them don't notice this slowing down, and they keep doing what they were doing as this high growth numbers will last forever, while the smart ones are selling their portfolios and making out of the market.

Then after one of less than expected quarterly report, and after quick but small down pulses in the index, the market will realize that there is no more of doubled profits, the late traders wake up and they start selling their portfolios quickly, and this will take the stock exchange index down for weeks, and this will never stop till the prices reach a fair level according to what is expected from the upcoming quarter reports.

Now, is there any sign for this upcoming crash?
Yes of course, you can see it. When the growth is still there, and we are at an early stage of the cycle, you will see the index making new record high every while. Whenever you notice that there is a level that the index couldn't break for a long while (usually couple of months or quarter period) this means that we reached a saturation level and don't ever think to enter the market at this point, there is something painful at the door.

Another sign that you can recognize easily, when you start seeing very high levels for AVG P/E ratio per industry or for all companies listed in the index, this means that the crash is close. Every stock exchange committee publishes such reports, showing AVG P/E ratio and some other useful figures, when you see AVG P/E for some industry more than 40-50, this is a very high AVG, and it's dangerous to get into this industry market at this point.

So does it mean that low P/E ratios are attractive to buy? Not always, because low P/E ratios might mean that the market sees no future growth for this industry or company. And if the market don't see hope in some industry, don't expect much of its share prices.
Of course there are some exceptions, where the market underestimates certain company, but it will quickly realize the situation and adjust its position.

"What To Buy?" is not the only question that you have to ask yourself before making a decision, but also "When To Buy?" timing is very important, you might buying the right share but at the wrong time.

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