Last Updated on 13 January, 2021 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:
The 1929 Stock 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
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.
What Caused It?
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.
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.
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