What is a stock market crash and why do they happen?
Oliver Brett July 23, 2021 4:18 PM
When shares drop dramatically across most constituents of an index, this is called a stock market crash. But it does not necessarily foretell a long-term decline. Read on as we explain more about a stock market crash.
What is the definition of a stock market crash?A stock market crash is a sudden drop in the value of equities across the vast majority of constituents.
When these share prices collapse, a significant loss of paper wealth for publicly quoted companies ensues. It also means a loss in the investment portfolios of individuals holding the shares.
A stock market crash is not the same as a bear market, which is defined by a gradual, long-term and sustained decline in a market. By contrast, a crash is a short, sharp shock to a market.
It could be part of a bear market, but equally it might be followed by a rapid rebound that brings stocks back to where they were before the crash.
Why do stock markets crash?There is often a sound macroeconomic reason that can trigger a stock market crash, but it doesn’t tend to explain the severity of the fall.
Steep drops are typically driven by a fear factor as “panic selling” comes into play. Clients will direct their brokers to liquidate their holdings to prevent their investments from dropping any further.
Sometimes excessive speculation creates economic bubbles in which share prices are artificially inflated. This is one of the most common catalysts for sparking a stock market crash.
What is the background to a typical stock market crash?
Negative economic events often provoke a sentiment of fear, leading some market participants to sell high volumes of stock and triggering many more to do the same. It creates what could be termed a “perfect storm” of factors contributing to crashes.
The following prevailing conditions are also vulnerable to crashes:
- A prolonged bull market based on excessive economic optimist
- A market where price–earnings ratios exceed long-term averages
- Extensive use of margin debt and leverage by market participants
- Wars, major socio-political unrest and terrorist attacks
- Major corporate cyber attacks, “hacks” and “fat finger” trading
- Changes in federal laws and regulations
- Natural disasters including pandemics
When do you know that a stock market crash has happened?
What are some historical examples of stock market crashes?
Tulip Mania – early 17th century
This is generally considered to have been the first recorded speculative bubble in history. Interestingly, when Bitcoin first crossed $30,000 in late 2017 some analysts compared this to “Tulip Mania”, and they were arguably proved right during the resultant crash the next year.
Panic of 1907
Wall Street Crash of 1929
Wall Street bankers allowed their clients – using margin debt and leverage - to enjoy the ride by floating investment trusts which specialised in those stocks.
The Dow Jones Industrial Average rose by 600% in eight years. But then it all went wrong. Forced to liquidate their stocks because of margin calls, over-extended investors flooded the exchange with sell orders.
The DJIA lost 89% of its value before finally bottoming out in July 1932. The crash was followed by the Great Depression, the worst economic crisis of modern times, which plagued the stock market and Wall Street throughout the 1930s.
Black Monday (1987)
Despite fears of a repeat of the Great Depression, the market rallied immediately after the crash, posting record single-day gains before the end of the month and it took only two years for the Dow to recover completely. Unusually, no fundamental reasons ever came to light to explain the 1987 crash.
Financial crisis of 2007–2008
It resulted in several bank failures in the US and Europe and sharp reductions in the value of stocks and commodities worldwide.
On October 24, 2008, many of the world's stock exchanges experienced the worst declines in their history, with drops of around 10% in most indices. The sell-off continued deep into 2009 and the recovery was slow.
What happened to global stocks in the pandemic?
Although the 2020 crash was severe, markets like the Dow Jones (above) soon recovered powerfully
The onset of the coronavirus pandemic caused a stock market crash in March 2020. As well as shares falling dramatically across the board, crude oil fell into negative territory for the first time.
Soon speculators looked to “safe haven” assets, such as gold, government bonds and Swiss francs to divert their assets, and then defensive stocks like utilities and healthcare.
The crash caused a bear market that proved miraculously short-lived. In April 2020, sentiment flipped; global stock markets re-entered a bull market, and by November US market indices had returned to the levels seen at the start of the year.
For much of 2020, volatility was exceptionally high across a wide variety of markets in a number of jurisdictions.
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