Stock Market Crash: Meaning, Causes, Effects and Examples
27 October 2022
Ups and downs in the stock market are considered normal. However, if a majority of equity prices or a representative group (stock market index) take a significant hit, it may lead to a situation known as the ‘stock market crash’.
Stock market crashes are rare events when most equities report value losses, while its aftereffects can be experienced for a long time.
This article will offer a deeper understanding of stock market crashes and what you should do if such a situation arises.
What is a Stock Market Crash?
When the prices of equities on a stock market move sharply downwards in a short period, it is termed a stock market crash. This is usually triggered by multiple events that share a single cause. When one or more indices experience a double-digit percentage decline, such a rapid fall characterises a crash.
It begins with the selling of stocks in large numbers. This selling could result from investor fear or panic. As the selling continues, these stocks flood the market, and thus the prices go down further.
What Causes a Stock Market Crash?
The surge in the stock market indices instil confidence in investors that the economy is booming, and thus they continue investing. Consistent stock gains and low unemployment rates are also drivers of bull markets, i.e. long periods of stock market highs. Historical data shows that crashes succeed long phases of economic growth.
When prices have been high for a long time, characterising a bull market, it means stock prices are at unsustainable levels and may go down. These high prices reflect greed and are far from the real value of companies based on earnings. An extended bull market is often an indication of a stock market crash coming.
Markets cannot keep going up indefinitely and slowly go down, leading to a crash. Financial analysts often make stock market crash predictions when the markets have been bullish for long periods.
In simple terms, the primary reason behind stock market crashes is the fear of investors that leads them to sell in large numbers. The common triggers for these crashes include unexpected economic events, speculations, natural calamities, war or other crises.
The recession of 2008 was one such stock market crash. It started when the stock market index Dow went low by 777.68 points. The New York Stock Exchange hadn’t seen a bigger point drop in history.
Lehman Brothers, along with other leading financial institutions in the U.S filed for bankruptcy. Investors panicked and started pulling their money out, leading to the stock market bleeding dry.
In recent times, technical developments like quantitative trading have also paved the way for crashes. Quantitative trading is the process of stock trading using computer programs empowered by mathematical algorithms. This caused a flash crash in May 2010.
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It is difficult to truly realise stock market crash meaning without understanding its aftereffects. Stock market crashes are often followed by a bear market. This means a market decline of 10% over a correction.
Correction here refers to getting back to the real prices from the unsustainable prices in the preceding bull market. Thus, a further decline of 10% from the correction means a total decline of 20% or more. This decline may also lead to a recession.
Equity positions fall significantly in value as stock markets crash. This sends investors into a frenzy. This is because they fear the value of their stock positions or retirement funds may decrease. As values go down, people have less capital at their disposal and they spend less. This plummeting consumer sentiment also leads to economic turmoil.
Dramatic stock price declines also hinder the ability of corporations to grow. This is because they derive capital from stocks to grow and manage their businesses. In the absence of this capital, the companies go into the cost-cutting mode to stay afloat.
This leads to layoffs. The laid-off workers thus are not in a position to spend more and reduce their expenditures. This causes a dip in economic activity, reduces demand and generates less revenue. Reduced revenues lead to more layoffs and eventually a recession.
The infamous recessions like the great depression, the 2001 recession and the great recession of 2008 were all preceded by stock market crashes.
Example of a Stock Market Crash
The dot-com crash of 2001 is a textbook example of a stock market crash. IT started with the advent of the internet and a boom in the number of internet-related companies. The investors thought of it as a profitable opportunity and started investing in the new avenue- eCommerce.
As an increasing number of investors took the plunge, the valuations skyrocketed and the market values went above and beyond the realistic profit-yielding capabilities of the companies.
This led to venture capitalists investing in dot-com companies to help them go public. The opening days were overpriced and the venture capitalists cashed out their investments.
The year 2000 was also the year when interest rates started increasing. As the dot-com companies performed poorly, it caused panic in the markets and investors started selling rapidly. This caused the bubble to burst. The result was catastrophic. The Nasdaq Composite Index which was high on IT stocks fell by more than 75% from its highest value in March 2000. This led to a recession.
Despite the bear conditions, the market still held on. However, the vulnerable and weak economy got a huge blow when the stock exchanges were shut down for days due to the 9/11 attacks in New York City. This caused the market to crash upon reopening on September 17.
The Biggest Stock Market Crashes in History
Below are the biggest stock market crashes in history that can equip investors with a better knowledge of stock market crashes:
1929 Black Tuesday: On October 29, 1929, nearly 16 million shares were traded on the New York Stock Exchange. The market dropped by nearly 12% and subsequently lost approximately 90% of its value
1987 Black Monday: On October 19, 1987, the Dow Jones Industrial average dropped by 508 points. This was a disastrous 22.6%
2001 Dotcom Bubble: This was a phenomenal economic catastrophe as it wiped off several years of gains. NASDAQ dropped 77% and consequently led to a loss of billions of dollars
2008 Financial Crisis: On September 29, 2008, the Dow Jones Industrial Average went down by 777.68 points followed by a continuous decrease for 18 months. This led to a loss of nearly 50% in Dow Jones value
2020 COVID-19 Pandemic: This was a short-term crash that started on February 20, 2020, as the S&P 500 dropped by 12% and the Dow Jones Industrial Average tumbled by 11%.
Should You Buy or Sell During a Crash?
Most stock market crashes are characterised by panic selling where investors contemplate the worst to happen and encash their positions. Finance experts believe that it is ideal to not respond impulsively to a crash and stick to your long-term strategy of buying and holding.
This is because no one can accurately time the market and most experts also don’t get it right. Hence, some stocks that may be at an all-time low during a low could bounce back and prove to be amazing in the long run.
Financial advisors also advise buying securities that are priced low during a crash but are fundamentally strong. This can help to realise profits as markets recover. At the same time, it might give investors an opportunity to buy fundamentally strong stocks at cheap prices and hold them for the long-term to create wealth.
Also, everyone has unique investment portfolios and goals. Thus, following someone else’s strategy during a crash can be disastrous for your savings. It is a good idea to consult a financial advisor before taking major decisions with respect to your investments during a crash.
Stock markets move in cycles. They can neither go up infinitely nor take a freefall. Market corrections and crashes are a part of the economic cycle; stocks and market indices eventually recover from a crash. However, investors must pay attention to their portfolios, come up with a weather-resistant investment strategy and rebalance their portfolios whenever required.
A long-term and sustainable approach is thus a great way to invest. Taking measures to design your portfolio based on your risk appetite is the only way to stay afloat during market crashes. A strong portfolio has a diverse mix of securities that boom in bullish market conditions and try to minimise the impact of bearish trends.
FAQs on Stock Market Crash
Q1. What is a stock market crash?
Ans. A sudden price drop for multiple securities in the stock market over a short period is called a stock market crash. It leads to significant losses for investors. Stock market crashes are caused mostly because of panic selling due to speculations and global unrest.
Q2 What is the reason for a stock market crash?
Ans. There can be multiple reasons for stock market crashes. These include an overinflated economy, terrorist attacks or other global unrest, natural disasters, pandemics or speculations in the financial space.
Q3. Can investors profit from a stock market crash?
Ans. Yes, investors that adopt their strategies based on market conditions profit from stock market crashes. Also, sticking to a long-term strategy can help to realise profits in the long run. Diversification and investing in dividend-yielding stocks can lead to profitability during stock market crashes.
Q4. Can stock market crashes be prevented?
Ans. There is no definitive way to prevent a stock market crash. However, safeguards are often employed to prevent sudden crashes. These include trading limits, circuit breakers, etc.
Q5. What is the average length of a stock market crash?
Ans. There are both short-lived and long crashes. The typical duration of a stock market crash is 11-23 months, but the aftereffects can be felt for up to 5 years.
Before you go…
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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