The stock market is known for volatility. Stock prices fluctuate, regularly reaching peaks and valleys, but they usually work their way in an upward direction overall.
Then again, volatility isn’t directional. Stocks can go down too.
Every once in a while, panic selling on Wall Street leads financial markets through a downward spiral that wipes billions of dollars out of investor portfolios. These selloffs usually catch the masses by surprise and have a history of leading to economic hardships around the globe. But what exactly is a stock market crash? And are we headed for one?
What Is a Stock Market Crash?
A stock market crash is characterized by a rapid decline in stock prices, usually measured using stock market indexes like the Dow Jones Industrial Average (DJIA), Nasdaq Composite index, and S&P 500 index. Although there’s no textbook threshold for a market crash, most experts define the event as a 20% or larger drop in overall stock prices over the course of a few days or less.
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These market declines tend to trigger bear markets that typically last about 12 months.
Though market crashes are the result of fear and panic selling, they usually happen between prolonged bull markets. That’s why long-term investors rebalance and often add to their portfolios while valuations are lowest after a crash – they’re banking on the coming bull market.
What Causes a Stock Market Crash?
Market crashes see panic selling that leads to a steep drop in equity prices over a short period of time. Anything that can panic investors can lead to a crash, though at least one of these conditions tends to occur before a sudden downturn.
Extended Bull Markets Driven by Speculation
Almost every market crash in history followed an extended bull market. Going as far back to the crash that caused the Great Depression, you’ll find that it was preceded by the Roaring Twenties — a period before the existence of the Securities and Exchange Commission (SEC) when a mix of speculation and fraud sent stocks roaring for the top.
Toward the end of a bull market, investors feel like they have to buy now or they’ll miss the run at the peak. At the same time, share prices are overvalued using just about any valuation ratio.
Soon enough, investors realize overvaluations are becoming the norm and dump their positions, leading to a market crash.
Market Bubbles
Market bubbles happen when greed takes the place of adequate research in a specific sector. For example, the Dotcom Bubble started to build as the internet became more popular across the United States.
Fear of missing out, or FOMO led countless investors to buy stocks in any company with dot com in its name without adequate due diligence. These stocks climbed to ridiculous valuations before the bubble burst, leading to a widespread market crash in 2001.
Central Bank Monetary Policy
The Federal Reserve, or Fed, is charged with maintaining reasonable inflation and employment levels in the United States. It does so through monetary policy that either adds liquidity to or removes liquidity from the U.S. economy, typically using two tools:
- Interest Rates. When the Fed needs to spur economic expansion, it reduces interest rates, spurring lending across the country. When it needs to taper economic expansion, it increases rates, making consumers and businesses less willing to take out loans.
- Quantitative Easing & Tightening. When interest rates aren’t enough, the Fed uses its balance sheet. It adds debt to its balance sheet (quantitative easing), flooding the market with liquidity when it needs to create expansion. It sheds debt from its balance sheet (quantitative tightening) when it needs to taper growth.
When the Fed increases interest rates and does quantitative tightening, less liquidity across the country leads to lower corporate profitability. If these moves happen too quickly, they can lead to panic selling and a market crash.
Algorithmic Stock Trading
Recently, algorithmic trading — also known as quantitative trading or quant trading — has become an important market driver. Traders use complex algorithms built into computer programs to do the trading for them based on technical indicators and market conditions.
The 2010 “flash crash” was reportedly caused by a glitch in quant trading systems. Trading bots sent the DJIA down nearly 1,000 points in a matter of minutes. The crash was so significant that the SEC vowed to make changes to protect the market from such an event in the future, proposing new policies to maintain a fair and orderly market.
Effects of Stock Market Crashes
Stock market crashes aren’t just painful for investors. They affect everyone from corporate bigwigs to janitors. That’s because the stock market plays such an integral role in the economy.
The market was created as a way for corporations to access the capital they needed to grow, and it continues to serve the same purpose today.
When share prices fall, the downturn means corporations can’t access the funding they need as easily. As corporations lose their access to funds, they must make difficult decisions, often leading to layoffs. Of course, those who are laid off can’t spend as much money, starving corporations of further profitability.
At the same time, economic panic leads those who are working to save more and spend less, further starving the economy of liquidity.
In the end, if the Fed, investors, corporations, and consumers don’t find the right balance, an economic recession could set in. Moreover, with flourishing international trade and the USD being the world’s currency, a domestic economic recession can lead to a global financial crisis.
OK, enough doom and gloom.
Sure, everything above can and often does happen following a stock market crash. But these events are typically short-term. The market and the economy start moving in the right direction again less than a year after most.
Historical Stock Market Crashes
Market crashes are nothing new. In fact, the S&P 500 has fallen by 20% or more 12 times since 1950. Some crashes played a major role in how the stock market operates today.
Black Monday & Black Tuesday (Great Depression)
On Monday, October 28, 1929, U.S. stocks tumbled 13%. The move continued on Tuesday, October 29, 1929, when stocks fell nearly another 12%. The event followed the Roaring Twenties when speculation and fraud led the market to new heights.
The crash led to one of the most difficult economic times in U.S. history: the Great Depression. The economic dark cloud of the depression would hang over the United States for about 10 years before a silver lining would finally emerge.
Black Monday II (1987)
On Monday, October 19, 1987, the Dow Jones Industrial Average fell a whopping 22%. Unlike the previous Black Monday, speculation wasn’t running rampant, and the Wild Wild West days of the stock market were long gone thanks to increased financial regulation.
Some suggest that the event was the result of a longstanding bull market that begged for a correction mixed with risky algorithmic trading that exacerbated the selloff. However, no one has tied down a widely accepted cause for the crash to date.
The good news is this Black Monday proved to be a short-term event with no economic blues following the market crash.
Dot Com Bubble Burst
In the late 1900s, investors couldn’t get enough of the internet. Everyone knew the technology had the potential to change the world and wanted a piece of it in their investment portfolios.
Demand for any stock with dot com in its name skyrocketed, sending valuations through the roof. Even shell companies with nothing more than a hope to one day do something on the internet were getting bombarded with funding.
The tech-heavy Nasdaq peaked on March 10, 2000, and by early 2001, the market crash was in full steam. As the dot com bubble deflated, the Nasdaq lost nearly 77%, wiping billions of dollars out of the U.S. stock market. An eight-month recession followed.
The Great Recession of 2008
In the years leading up to 2008, mortgage companies were using shoddy lending practices and overvaluing homes, creating the real estate bubble. Over time, the bubble grew to unsustainable levels.
Those who signed up for subpar mortgages began falling behind, and the companies that handed out the loans using poor lending practices looked to the government for a bailout. Lehman Brothers was one of the first to seek a bailout.
The world watched as the bailout decision was handed down.
The government wouldn’t save Lehman Brothers and the market fell into a panic. Investors believed the move would be the first falling domino as other goliath financial institutions would go bankrupt. The stock market and housing market crashed leading to what many called the worst economic crisis since the Great Depression.
The Flash Crash of 2010
On May 6, 2010, just as the U.S. market began heading full steam ahead following the great recession, an unexpected event led the Dow Jones Industrial Average down nearly 1,000 points in minutes.
The crash was caused by a glitch in algorithmic trading software that resulted in millions of shares being sold and billions of dollars being wiped out of the stock market. Luckily, the event proved to be short-lived, and the market was back on the upswing by July. No recession — nor any negative repercussions — followed.
The Coronavirus Pandemic
In 2020, the first case of COVID-19 was diagnosed on United States soil. In the months that followed, non-essential companies were forced to close their doors, the stock market tumbled, and fear set in.
Nobody wants to be in stocks when the economy is closed to the public.
The S&P 500 fell more than 30% in a matter of weeks, and everyone seemed sure an economic recession was on the horizon. The Federal Reserve quickly slashed interest rates and hit the accelerator on quantitative easing efforts. At the same time, the U.S. government pumped stimulus checks into the economy.
As a result, the market and economy recovered far more quickly than expected, which may have teed up the next crash.
The 2022 Market Crash
By early June 2022, the S&P 500 was down by more than 20% year-to-date in what many argue is a market crash — though the market rallied shortly thereafter, shrinking losses to around 11% by mid-August.
Some experts suggest this is nothing more than a bear bounce, or a short term correction in a bear market. They expect the market to resume its longer-term decline. Others believe the upward move portends a lasting recovery.
Regardless of what happens ahead, there was at least a short period of time in 2022 when the S&P 500 was in bear market territory. There were several reasons for the most recent downturn in the market:
- Geopolitical Events. The war between Russia and Ukraine has led to sanctions, starving the global market of Russian-produced oil and other commodities and lending a hand to inflation.
- Interest Rates. Prolonged low-interest rates have led to excessive spending and liquidity in the U.S. market, resulting in inflation. The Fed rapidly raised interest rates with unprecedented 0.75% increases, leading to further panic among investors.
- Housing Crisis. Demand for homes in the U.S. is outpacing supply, leading to a housing crisis.
- General Inflation. Some experts argue that the Fed’s aggressive quantitative easing and rate cuts in the face of the COVID-19 pandemic, mixed with government stimulus packages, are backfiring – acting as the primary reason for historically high inflation rates.
As of yet, there’s no way to tell if a recession will follow this most recent market crash.
What to Do in a Stock Market Crash
The first thing you want to do when the market crashes is take a second to breathe. Emotion-led investment decisions tend to lead to losses. Here are a few tips to turn the lemon that is a market crash into lemonade:
- Maintain Balance. You designed your portfolio with a balance between risk and reward. Maintain balance by ensuring your asset allocation is in check and rebalancing regularly as the storm blows over.
- Assess Your Allocation. You’re probably a bit more fearful than you were when you built your portfolio. That’s fine. Adjust your allocation strategy to match your current risk tolerance.
- Maintain Heavy Diversification. Make sure your stock allocation is heavily diversified. You can do so easily by focusing the majority of your stock holdings on non-cyclical mutual funds and exchange-traded funds (ETFs).
- Look for Opportunities. Market crashes are a great time to buy shares of quality companies at discounted market values. Just be sure to do your research before making any moves in a bear market.
- Practice Dollar-Cost Averaging. Average out your entry cost by making purchases in equal dollar amounts of the stocks you want to buy across predetermined intervals. For example, if you want to buy $500 worth of Apple stock, buy $100 worth per week for five weeks. This way, you know you’re not buying in at the top or missing out on the rebound as a reversal happens.
Safeguards Against Stock Market Crashes
The government and major stock exchanges have put two safeguards in place to protect the market by slowing the effects of market crashes. Those safeguards include:
- Circuit Breakers. Circuit breakers are thresholds measured by single-day declines. For example, the New York Stock Exchange (NYSE) has three circuit breaker thresholds: 7% (Level 1), 13% (Level 2), and 20% (Level 3). When Level 1 and 2 circuit breakers are triggered, trading is paused for 15 minutes. When a Level 3 circuit breaker is triggered, trading is paused for the rest of the trading day.
- Plunge Protection Team. The Plunge Protection Team is headed up by the Secretary of the Treasury who leads members like the Chair of the Board of Governors of the Federal Reserve, the Chair of the SEC, and the Chair of the Commodities Futures Trading Commission (CFTC). The Team provides financial and economic recommendations to the President during turbulent market conditions.
Some institutional investors also attempt to reduce the effects of market crashes by purchasing large numbers of shares. This practice was started by J.P. Morgan in the early 1900s but has not been proven effective to date.
You should have your own safeguards in place too. Some of the best ways to protect yourself from a market crash are to follow your investment strategy, pay close attention to your asset allocation, maintain heavy diversification, and rebalance your portfolio regularly.
Stock Market Crash FAQs
Market crashes are significant events that often have a profound impact on the U.S. and global economies. However, unless you’re an economist or have a financial background, chances are you didn’t learn much about them in school. So, it’s normal to have a few questions.
What Are the Signs a Stock Market Crash Is Coming?
There are several signs when a stock market crash is coming. One of the most telling signs is high market valuations. Crashes typically happen following prolonged bull markets after investors have sent stock valuations to new heights. If you find it difficult to spot undervalued opportunities, a crash may be on the horizon.
Some other signs include prolonged dovish monetary policy, flattening corporate profits, rising inflation, domestic and geopolitical uncertainty, and weakening economic indicators.
Will I Lose Money if the Stock Market Crashes?
If you have money in the market, chances are you’ll take a loss when a market crash sets in — on paper, at least. You won’t realize the loss unless you sell when prices are low.
The size of your loss, and how quickly you recover, depends on how you handle yourself in the face of a crash. Stay calm and think logically about your next moves and you should be fine in the end.
What’s the Difference Between a Market Crash & a Market Correction?
A market correction is characterized by a 10% or larger drop in value over a period of time ranging from days to months. Corrections are caused by high valuations following prolonged bull markets.
On the other hand, crashes are characterized by a 20% or larger drop over a short period of time and can be caused by a wide array of factors.
Final Word
Market crashes and the potential for economic recessions to follow are scary occurrences. However, you should never let fear drive your financial decisions. Always invest with a level head, even in the face of adverse market conditions.
Protect yourself by doing solid research before making investment decisions, maintaining a diversified portfolio, and rebalancing your portfolio from time to time. Emotions and panic are what lead to these conditions in the market, and they won’t do anything to help you come out ahead.