December 11

Why Do Stock Market Crashes Happen? (Causes and Explanations)

Last Updated on 11 December, 2022 by Samuelsson

There have been several stock market crashes in history, and you may have witnessed a few of the most recent ones as a trader or, at least, heard about them. But, have you bothered to know why the stock market crashes happen?

Generally, a stock market crash happens when market participants massively dump their stocks out of fear of a market collapse. The panic selling could be triggered by the extreme overvaluation of stocks, changes in federal regulations, overinflated economy, natural disasters, sociopolitical events like war or a terrorist attack, and extensive use of margin and leverage by market players.

Stock market crashes can wipe out a significant chunk of paper wealth from investors who hold stocks, but fortunately, all stock market crashes in history have always recovered, though some took longer than others. Keep reading to learn more about market crashes.

What You May Not Know About Market Crashes

Do you know that the first stock market crash was as a result of the Dutch tulips?

Well, the tulip was imported to Holland in the 16th century. With time, the Dutch elite saw it as a symbol of high status, owing to its extraordinary beauty, so the demand for tulip went up, pushing the price higher. The increasing prices attracted speculators who wanted to profit from the rising prices. By 1637, the interest in tulips has declined, and the market crashed.

Definition of Stock Market Crashes

Generally, there’s no formal definition for stock market crashes, but they are considered as rapid drop — of at least 10% point — in a broad stock market index, like the S&P 500 Index or Dow Jones Industrial Average (DJIA), over a period of few days. Historically, a double-digit percentage drop is fairly common in the stock market.

In recent times, there has been growing concern that stock market indexes could drop huge points in a matter of minutes due to high-frequency trading from computer programs, leading to what is known as a flash crash — May 2010 for example. To prevent such algorithm-caused flash crashes, the SEC has introduced some circuit breakers that will temporarily halt trading in any stock if there’s an unusually sharp decline in the stock’s price.

There have been many market crashes in the U.S. stock market, but here, we will discuss four examples and why they happened:

What happens when the stock market crashes?

When the stock market crashes, it can have a major impact on the economy. When the stock market crashes, shares of stock, which represent ownership in a company, suddenly become worth much less than they were before. This can lead to a decrease in the value of investments, and people may lose a great deal of money.

The effects of a stock market crash can be felt far and wide. When the stock market crashes, investors may panic and sell their shares in order to minimize their losses. This can cause a ripple effect as the market continues to fall and more investors rush to sell their stock. This can lead to a decrease in the overall value of the stock market, as well as a decrease in confidence in the market.

The stock market crash can also lead to a decrease in consumer spending. When people lose money in the stock market, they may be less likely to spend money on other things, such as luxury items, vacations, or investments. This can lead to a decrease in economic activity, and can be felt in businesses across the country.

The stock market crash can also lead to a decrease in business investment. When businesses lose money in the stock market, they may be less likely to invest in new projects or hire more employees.

The 1929 Stock Market Crash

Market Crash
Market Crash

Probably the most famous stock market crash in U.S. history, the 1929 stock market crash brought an end to the market boom of the 1920s. It started on the 24th of October 1929 — a day, popularly known as the Black Thursday — and lasted till Tuesday, the 29th of October, 1929 (the Black Tuesday).

On the Black Thursday, the DJIA lost about 11% of its value in early hours but recovered most of that later that day, when the bankers intervened. The next day, October 25th (Black Friday), the recovery continued. But being scared of the Thursday’s slide and out of fear of getting margin calls, investors massively sold their shares on Monday, leading to a 13% drop in DJIA. On Tuesday, the DJIA dropped another 12%.

The crash was so devastating, wiping out billions of dollars in market value. It didn’t only affect the individual investors but also affected the banks and companies that were hugely invested in the market. Several banks folded, and people lost their life savings. In fact, the 1929 stock market crash heralded the Great Depression — an economic slump that took the US over 12 years to recover.

Why Did the Crash Happen?

Before the crash, the economy was booming — there’s increasing sales in autos and homes — and stock prices were hitting the roof. With so much optimism about the stock market, many investors bought stocks on margin and couldn’t pay up when the margin calls started coming.

So the factors that led to the crash were economic hyperinflation, overvaluation of stocks, and excessive use of margins in trading. Of the three factors, margin trading was the major reason for the steep decline.

The 1987 Stock Market Crash

Dubbed the Black Monday, the 1987 stock market crash is the biggest single-day loss in the DJIA history, percentage-wise. The DJIA lost about 23% of its value on a single day — the 19th of October, 1987. Following the crash in DJIA, other major stock markets around the world began to decline.

Unlike the 1929 crash that took more than 12 years to recover, the 1987 crash started recovering the day after the Black Monday and topped the pre-crash high in less than two years. Although many investors lost money, the effect on the general economy was not like the Great Depression.

What Caused It?

Of course, prior to the crash, most stocks were overvalued, and there were other factors like margin accounts and leveraged corporate takeovers. But it is generally believed that panic selling and computerized high-frequency trading were the major culprits.

Since then, the market regulators installed circuit breakers or trading curbs into computer trading platforms, which can allow the regulators to suspend trading activity in situations of rapid stock price declines.

The Stock Market Crash of 1999-2000

The stock market collapse of 1999-2000 was not as rapid as the 1987 crash, where the market lost 23% in one trading day. It was a slow but steady decline over a longer period of time. Also known as the Dot.com Bust, this market crash was caused by the proliferation of internet companies.

In the 1990s, investors recognized the value of the internet and started acquiring the stocks of dot.com companies with reckless abandon. This drove the prices high, and the Nasdaq Index, a tech-heavy stock index rose from 1000 to 5000 in five years (from 1995 to 2000).

What led to the crash?

Obviously, the main factor that led to the crash was the extreme overvaluation of stocks, especially stocks in the technology sector. Investors were speculating on stocks that had little or no fundamental value, creating a bubble — what Alan Greenspan, the then Federal Reserve chairman, would call irrational exuberance. As expected, the bubble later bust, and the Nasdaq Index fell from 5000 to 1000 in less than two years.

The Stock Market Crash of 2008

Stock Market Crash
Stock Market Crash

This stock market crash is also known as the Great Recession market crash, as it was triggered by a cascade of events that almost sank the U.S. financial sector. The collapse of big financial institutions, like Lehman Brothers, Bear Stearns, and Washington Mutual, was the hallmark of the Great Recession.

Stock prices fell so badly that by the time the bear market eventually bottomed in 2009, the DJIA had lost about 54% of its pre-crash value. Expectedly, the financial stocks were worst hit, despite the fact that the SEC instituted a temporary restriction on short-selling financial companies.

The 2008 stock market crash pushed the U.S. economy into a big recession, and the government had to formulate a stimulus package to drive the economy out of recession. The ripple effect of this crash was felt all over the world, as most of the big economies were plunged into recession. Different countries had to find ways to stimulate their economies out of recession. In fact, in some places like Europe, the stimulus package was still ongoing as of 2019, since inflation had not been able to reach the expected target.

Ccauses of a stock market crash?

The 2008 stock market crash was caused by the 2007 housing crisis. Banks and mortgage companies issued huge loans to homeowners who couldn’t afford to pay back. To manage the risk of defaults, banks (Lehman Brothers) and mortgage companies created complex financial derivatives — mortgage-backed securities and repurchase agreements (repos) — and sold to investors and fund managers.

As the housing crisis started, these derivative products became worthless, and the financial institutions that backed them became bankrupt. The failure of these banks sent the stock market crashing down. The U.S. Congress had to approve a huge fund that allowed the Federal Reserve to buy up the toxic mortgage securities.

A stock market crash is a sudden, sharp decline in the prices of stocks in one or more stock markets. It is usually triggered by a shock event or a combination of several underlying factors. The most common causes of a stock market crash include:

1. Economic Slowdown: A slowdown in the economy can cause a stock market crash. This is usually due to a decrease in consumer spending, a decrease in business investment, and an increase in unemployment. When the economy is weak, investors become more wary of investing in stocks, and may choose to sell their shares in order to take advantage of lower prices.

2. Political Uncertainty: Political uncertainty can also cause a stock market crash. Investors may become concerned about the policies of a particular government, or the potential for changes in government leadership. This can cause them to become more cautious when it comes to investing in stocks, and they may choose to sell their shares.

3. Inflation: Inflation can cause a stock market crash because it erodes the value of investments. When prices rise rapidly, the value of stocks may decline in response. This can cause investors to sell their shares in order to protect their investments.

4. Natural Disasters: Natural disasters such as earthquakes and floods can cause a stock market crash. Investors may be concerned about the potential for losses due to damage to businesses or infrastructure, and may choose to sell their shares in order to protect their investments.

5. Fraud: Fraud or other unethical business practices can also cause a stock market crash. When investors become aware of fraudulent activities at a company, they may lose confidence in the company and its stock price, causing them to sell their shares.

6. Excessive Speculation: When investors become overly optimistic about a particular stock, they may start buying up large amounts of its shares, causing its price to increase rapidly. This can lead to a stock market crash if other investors become worried that the stock is overvalued and decide to sell their shares to take advantage of the lower prices.

What happens if the stock market crashes?

If the stock market crashes, it can have a devastating effect on the global economy. A stock market crash is when the stock market experiences a significant and rapid drop in the prices of stocks. This usually happens due to a significant global event or economic downturn, and can cause a ripple effect throughout the world.

When a stock market crash occurs, it causes panic among investors as they fear that their investments could lose value. This can lead to a period of market volatility as investors try to assess the impact of the crash and decide what to do with their investments.

When the market crashes, investors often sell off their stocks in an effort to protect their capital. This can cause the market to become even more volatile as more stocks are sold off, causing a vicious cycle. This can lead to a rapid decrease in stock prices, and a significant decrease in the overall value of the market.

At this point, the economy can suffer significantly. Companies may have to lay off employees and cut back on production, leading to further economic decline. Businesses may struggle to stay afloat, as consumers tighten their budgets and spend less. This can further hurt the economy and lead to a recession.

The effects of a stock market crash can be long-lasting and can take years to fully recover from. It is important for investors to remain vigilant and be prepared for a potential market crash. It is also important to diversify investments to help protect against potential losses.

Stock market crashes in history

A shorter summary of the above:

1. Black Tuesday, October 29, 1929: The most famous stock market crash in history, Black Tuesday occurred in 1929 and marked the beginning of the Great Depression. It was the largest single-day stock market drop in history, with the Dow Jones Industrial Average (DJIA) dropping nearly 13 percent. The economy was already in decline before the crash, but the stock market crash was the tipping point that sent the US economy into a full-blown depression. The crash was caused by a combination of over-speculation in the stock market, a lack of investor confidence, and a lack of government intervention.

2. Black Monday, October 19, 1987: On this day, the DJIA fell 22.6 percent, making it the largest one-day stock market crash in history. The crash was caused by a combination of computer-driven trading, investor panic, and a lack of liquidity in the market. The crash was so sudden and unexpected that it was dubbed “Black Monday.”

3. The Dot-Com Bubble, 2000-2002: The dot-com bubble was a period of extreme speculation in internet-related stocks that took place between 2000 and 2002. During this time, investors poured money into internet-related stocks in the hopes of making a quick profit. When the bubble burst, the NASDAQ fell 78 percent and many investors lost their entire portfolios.

4. The Financial Crisis of 2008: The financial crisis of 2008 was the worst economic crisis since the Great Depression. It was caused by a combination of reckless lending and investments, derivatives, and a lack of government oversight. The Dow Jones Industrial Average fell more than 50 percent from its peak before eventually recovering.

5. The Coronavirus Crash of 2020: As the coronavirus pandemic spread, the stock market experienced its worst crash since the Great Depression. The Dow Jones Industrial Average plunged 34 percent from its peak before eventually recovering. The crash was caused by a combination of investor panic, uncertainty, and a lack of government intervention.

What goes up when the stock market crashes?

When the stock market crashes, it means that the overall market has decreased in value. This means that the value of stocks, bonds, and other investments has decreased. In general, when the stock market crashes, the prices of stocks and other investments go down. This is because investors are selling their investments in order to avoid further losses, which causes the prices of these investments to decrease.

At the same time, however, the prices of certain other investments, such as gold and commodities, may go up. This is because investors may be looking to buy these items as a hedge against a stock market crash. When investors believe that their stocks may decrease in value, they may look to buy items such as gold or commodities in order to protect their investments. This can cause the prices of these items to increase as investors rush to buy them.

In addition, when the stock market crashes, the prices of certain bonds, such as government bonds, may also rise. This is because investors may be looking to move their money into safer investments such as government bonds when they believe that the stock market is going to continue to decline. This can cause the prices of these bonds to increase as investors buy them in order to protect their money.

Overall, when the stock market crashes, the prices of stocks and other investments generally go down. However, the prices of certain other investments, such as gold and commodities, may go up as investors look to buy these items as a hedge against further losses. In addition, the prices of certain bonds, such as government bonds, may also rise as investors look to move their money into safer investments.

Biggest stock market crashes in history by percentage

1. Wall Street Crash of 1929:
The Wall Street Crash of 1929, also referred to as the Great Crash, was the most devastating stock market crash in the history of the United States. It happened on October 24, 1929, and marked the beginning of the Great Depression. The Dow Jones Industrial Average dropped by an alarming 23.8%, closing at 230.07 points. Around 16.4 million stocks were traded on that day, a record that would not be broken for almost 40 years. The crash was a result of a combination of factors, such as overvaluation of stocks, a stagnant economy, and a lack of investor confidence.

2. Black Monday 1987:
Black Monday 1987 was the second-worst stock market crash in history, with the Dow Jones Industrial Average plummeting 22.6%. It occurred on October 19, 1987, and resulted in a global stock market crash. The crash was fueled by several factors, including program trading, portfolio insurance, and overvaluation of stocks. The crash had a worldwide impact and was a major contributor to the 1987 recession.

3. The Dot-com Bubble of 2000-2002:
The Dot-com Bubble of 2000-2002 was a period of excessive speculation in Internet-related stocks. The bubble was fueled by the rapid growth of internet use and the belief that companies would be able to monetize their online presence. The Nasdaq Composite Index peaked at 5,048.62 on March 10, 2000, before falling 78% to 1,108.49 by October 9, 2002. The crash was a result of overvaluation of stocks, a lack of profitability, and investor panic.

4. Global Financial Crisis of 2008:
The Global Financial Crisis of 2008 was a major financial crisis that affected markets around the world. The crisis was triggered by the collapse of the U.S. housing bubble and the resulting subprime mortgage crisis. The Dow Jones Industrial Average dropped 54.2% from its peak in October 2007 to its trough in March 2009. The crisis was caused by a combination of factors, such as excessive risk-taking in the banking sector, lax regulation, and a lack of investor confidence.

How many stock market crashes have there been?

Since the beginning of the stock market, there have been numerous stock market crashes. The most famous of these include the Wall Street Crash of 1929, which is also known as the Great Depression, the 1987 stock market crash, and the 2008 financial crisis.

The Wall Street Crash of 1929 is considered the most severe financial crisis in US history. It began on October 24, 1929, when the Dow Jones Industrial Average dropped 11 percent in a single day. The crash was caused by a variety of factors, including overvaluation of stocks, speculation, and a lack of confidence in businesses. The stock market crash led to an economic depression that lasted for over a decade and cost millions of Americans their jobs and homes.

The 1987 stock market crash, sometimes referred to as Black Monday, occurred on October 19, 1987. The Dow Jones Industrial Average lost 22.6 percent of its value, the largest single-day percentage decline in history. The crash was caused by a combination of factors, including excess speculation, computer-programmed trading strategies, and a sharp decline in international stock markets. The crash was followed by a recession that lasted for five months.

The 2008 financial crisis was the most recent major stock market crash. It began in 2007 when the subprime mortgage market imploded. Banks and financial institutions had invested heavily in subprime mortgage securities, which quickly lost their value as the housing market collapsed. This caused a liquidity crisis that spread throughout the financial system, leading to a global recession. The stock market responded by plummeting and the Dow Jones Industrial Average eventually lost over 50 percent of its value.

These are just a few of the many stock market crashes that have occurred over the years. Other notable crashes include the 1973–74 stock market crash, the dot-com bubble of the late 1990s, and the stock market crash of 2020 due to the COVID-19 pandemic.

Conclusion

Stock market crashes happen as a result of panic selling of stocks, which could be triggered by the changes in federal regulations, extreme overvaluation of stocks, overinflated economy, natural disasters, sociopolitical events like war or a terrorist attack, and extensive use of margin and leverage by market players.

If you enjoyed this article you may also like our other articles answering common questions traders have!

Also, what often follows a market crash, is a bear market. But how long will a bear market last?


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