The very mention of the term, stock market crash can be rather intimidating.
You are reminded of panicked sellers, huge losses, and a sense of gloom across the trading floors.
Almost inevitably, being stuck in a stock market crash remains every investor’s worst nightmare.
You undertake series of precautionary measures to safeguard against a potential crash.
But it is not the market crash alone that you need to take into consideration.
You have to take into account the various economic ramifications before and after a crash and its bigger impact on the overall development process.
Stock Market Crash Definition
So how would you define stock market crash?
In very simple terms, the stock market crash definition would be any sudden and drastic fall in stock prices across a major cross section of the stock market.
Invariably, you would notice that a crash in the market is driven by several factors like panic, economic aspects and many other related factors.
1. Correction or Crash
You can ask why we can’t call it a correction in stock markets.
Well indeed we can but when this correction exceeds 10% or more in intra-day trade, we call it stock market crash.
Almost inevitably the stock market crash is the logical consequence of the various speculative actions in the market.
Almost always this kind of market bubble results from a multiple of factors.
On an average, you can expect a stock market crash when you see the stock prices rising for an extended period or you notice that there is unusual euphoria in the market with regards to a specific news or catalyst for that matter.
In other words, this additional optimism in the market often results in stretched market valuation and this invariably results in stock prices correcting eventually and resulting in a stock market crash.
2. Stretched Valuation
By stretched valuation I mean, the average price-to-earnings ratio of stock prices breach the long-term price averages.
Overleveraging of market forces as a direct extension of these speculative elements is also a key catalyst that could result in a crash.
An irrational use of the marginal debt can also contribute to the unusually large correction in the broad stock market prices and not just individual entities.
But when you set out to look for a stock market crash definition, you must understand that there is no structured definition of this market phenomena.
In many ways, it is also a relative concept that comes to play.
But what is important is undoubtedly the drama element.
Per se, if you are looking for a mathematical justification or broad-based definition, there is, in fact, no way to exactly substantiate what you understand by the stock market crash.
3. Rapid Fall in Prices within a Very Short Time
That is exactly why the easiest and the most common definition for a stock market crash is undeniably a double-digit dip in prices that results in significant value erosion of not just individual stocks but overall market prices.
Normally compared to a fall, when you have a crash in the market, it continues for a prolonged period.
It does not end in just one go.
Invariably, the spate of decline continues for a fairly long period of time.
Normally, it is the rapid fall in prices within a very short time that makes a stock market crash stand out.
But, yet again there is a big difference between what you can term as a crash and what would be called a bear market.
Traditionally, the bear market extends for months and even years while a crash is a fairly temporary development.
But it is also a fact that often a stock market crash could be a precursor of a bigger fall in the markets or even a period of extended market decline that can be eventually termed as a bear market.
But it is not always true either.
4. Stock Market Crash of 1929 as an Example
While the stock market crash of 1929 led to a huge depression and a bear market in 1929 in the US, the big US stock market crash in 1987 did not result in a bear market.
Another example would undoubtedly be the Japanese bear market in the 1990s.
You saw this phase extend over several years without any distinct stock market crash to report home about.
What Causes Stock Market Crash
Once you have a fair idea of what is stock market crash definition, the next important question in this context is undeniably what causes this crash.
Well, there can be several factors contributing to the eventual crash in stock prices.
1. Panic Selling:
Almost inevitably the first and foremost reason behind a stock market crash is panic selling.
There can be a lot of triggers for panic in the market.
Starting from a news release to political development to implementation of a market policy, there are many reasons that could potentially result in a crash in stock prices.
Essentially in a panic situation, shareholders begin to doubt the profit prospect of their holdings and want to limit future losses.
The whole fear factor then leads to a huge depreciation in value of stock prices and that eventually leads to the key indices recording double-digit losses.
Invariably panic in stock market follows an irrational bubble in the market.
During that period, we see the stock prices rising very high without any reasonable justification.
When prices keep rising on speculation, investors almost invariably anticipate the panic situation setting into the market and resulting in losses.
Something unique about a panic selling situation is that the price of the stocks just before the panic selling and stock market crash are extremely stretched.
There is almost an irrational up move and often the price to earning ratio is unable to justify the stock price.
The prices move far higher than fair value level and this is exactly where the trouble begins to set in.
2. Quantitative Trading:
One of the most recent triggers for a stock market crash has been ascribed to a rather new phenomenon, quantitative trading.
This is a comparatively recent development that triggered massive declines in the market.
Essentially, in this case, the quant analysts in stock markets took help of mathematical algorithms in existing stock market programs to trade.
You have a highly developed software that was operated by a huge number of computers and was so programmed that it would trigger a sell at a certain price point.
This is often even related as well.
The result was panic in stock market and eventual stock market crash.
Just imagine when you have a large number of programs tuned to sell at the same point, the average investor sure gets worried and tries to anticipate the possible triggers and therefore looks at booking profit.
This program based trading has been the cause for concern and panic in the markets quite a few times.
3. Economic Policy:
I am sure you have seen the way the market is apprehensive and trading is impacted ahead of any Fed Policy announcement.
Now let’s look at the various steps taken by the US Federal Reserve.
Lots of times when the Fed decided to not raise the borrowing rate or continue with its no rate hike policy, or for that matter any such related steps, it resulted in adverse market movement.
So, you can now understand market movement is very closely linked with economic developments and how they impact the prospect of generating future returns.
Therefore, if there is any economic policy that impacts the markets negatively, it can surely trigger a stock market crash.
You have to understand that the severity of the entire crash will depend on how or what the news impacts.
Sometimes economic policy also alters the course of global demand and supply dynamics and this can often change how not just individual stocks respond but also how the market reacts.
This is exactly why it becomes such an important trigger for potential stock market crash.
4. Political News:
Another major trigger for stock markets is decidedly the political developments in the country.
As we have seen in the case of a few US stock market crash, sometimes political news can really trigger a huge fall in the market, essentially if the fall is triggered by panic amongst shareholders about the potential impact of a possible political development.
The market might sometimes interpret a certain development as negative for the future prospects of the country and that is how the panic settles in the entire market.
This is what will then lead to a sell-off and eventual stock market crash.
Sometimes the political development might not be in your country.
But if the relevant information is in anyway with a negative connotation for the future of your country’s political development, then it will surely lead to a sell-off in the markets and eventually result in stock market crash.
5. Geo-Political Development:
If you ever followed crude oil prices, I am sure this fact will be very clearly highlighted in the manner how a news trigger can impact market movement.
For example, let’s say that a war has broken in some part of the world and several global superpowers are involved, it is bit obvious that there would be ramifications on the overall economic and monetary picture of the country.
You are not sure about the fund flow might be impacted and this will surely result in some sort of panic in stock markets.
Needless to mention therefore that if the trigger becomes relatively serious, the ramifications too can take on a far more difficult undertone and that can result in stock market crash.
Can You Predict Stock Market Crash Mathematically?
Often the quant analysis in the market makes you wonder if there is a mathematical way to predict a stock market crash?
You did not have to worry about set valuations, explore stretched levels and simply based on some easy calculations, you would have known when it is time to sell!
Wishful that sounds but have you explored if you can actually predict a market fall in this manner?
In fact, if you notice overall, the mathematical description and analysis of markets using them has been subject to intense discussion and debate.
As early as 1963, several mathematicians had begun probing the link between large movement in stock markets and their non-linear analysis and explanation as per the Chaos Theory.
In fact, some studies have even indicated that stock market crash followed the cubic law and could even be interpreted as a sign of a kind of ‘self-organized criticality’ by Prof Didier Sornette.
In fact, researchers continue much further analysis linking the various index movements and the potential link to a stock market crash.
Computer simulations have often been used to create crowd hysteria like the situation to exactly understand the possible link between these crashes and the market movement.
– One Year Just Before a Stock Market Crash
In fact, while researching the various links, it was observed that a rise in the market mimicry continues to happen for one year just before a stock market crash.
Surprisingly, this fact stands true for every market crash in last 3 decades or so and even before the financial crisis in 2008, the mimicry reached a pinnacle.
Obviously, this fact clearly highlights how we can use this data to create a warning mechanism to help deal with the market movement and perhaps even look at creating a warning mechanism.
Don’t you think it would be really cool if you just knew the moment the stock market crash would happen and therefore act according to it?
There are some interesting mathematical corollaries that have been drawn with regards to the market reversals.
Calculations indicate that there has been an inexplicable link between stock market crash and almost 10-40% reversal in just a month’s span.
Therefore, it can be easily said that there sure is a clear link between the stock market crash and mathematical analysis of it.
However, research is underway and the links are not clearly established between them.
In many ways, it is a concept that is replete with potential but the overall concept would need far more probing and investigation.
Stock Market Crash of 1929
The moment you talk about the stock market crash, it is impossible not to mention the stock market crash of 1929 and depression that it triggered.
In fact, in many ways, it was not just the earliest stock market crash but also a completely new experience for investors.
Suddenly, shareholders realized the spine-chilling impact of a trade going bad.
The share prices kept falling for over 4 days and the total value erosion reached as much as 25%.
The stock market crash began on October 24 and has been hence called as Black Thursday.
Prices nosedived as much as 11% and then recovered some bit.
Nearly 13 million shares were sold in a single trading session.
This was in fact more than 3x the average volume.
When trading began the next day, Friday, it seemed stocks were back to business but the mayhem continued and the market bled another 13% the following Monday and that is how the term Black Monday came into being.
The downslide continued relentlessly and the next day, Black Tuesday saw another 10%+ fall in the indices.
Business came to almost a standstill in the course of these four trading sessions.
The 1920s till then was a fairly positive phase in US economy.
Economic activity was thriving, technology advanced and you had many modern new age innovations unveiling like automobile, radios and aviation.
In fact, stocks like General Motors, Radio Corporation and a variety of financial corporations were the toast of Wall Street.
Bankers began to float mutual funds and investment trusts and the easy returns that the stock markets were generating became the opium of the common man.
Needless to mention that this also meant that the valuations were stretched and the markets were over leveraged.
As a result, the economy gradually started shrinking and the summer of 1929 saw some massive price declines.
Finally, the unravelling of market forces began and the eventual stock market crash started on October 29.
By the time Black Monday set forth, the overall deluge of sellers almost tripped the trading system.
Telephone lines, the heart of the entire trading mechanism at that time was absolutely clogged.
Fear and panic gripped the investor circle and the jamming of telephone lines led to a further vacuum in the market.
The entire information channel got completely clogged and there was a huge vacuum that further aggravated the problem.
The problem worsened the following day, Black Tuesday.
It was complete mayhem and chaos on Wall Street.
Investors were forced to sell their assets because margins started getting triggered.
Badly leveraged investors flooded the exchange.
They were trying their level best to get rid of the stocks.
The result: the markets slumped even further.
By the time the week ended and the weekend arrived, the US stock market crash equaled close to almost 40% from its September highs.
There was, of course, some rally soon after in the months that follow but the bigger bear market had set in.
The stock market crash of 1929, unveiled the most talked about depression in US economy.
The Dow in this period lost almost 90% and finally bottomed out by the middle of 1932.
It was perhaps one of the most tiring phases and most talked about US stock market crash.
Investors had clocked in such huge losses and the stock market crash ushered in such a period of uncertainty that it took quite some time before they actually gained faith and began investing once again.
In fact, the traces of the stock market crash of 1929 continued to plague the market sentiment almost as late as the 1950s.
The Dow Jones, one of the marquee and most extensively traded US indices did not recover to its pre-1929 crash levels almost till 1954.
Perhaps the road to recovery started from their and slow and steadily indices began to scale back to new highs.
Investor confidence too began to move up and the overall response to market gradually started again recovering.
Learn more about this stock market crash: Stock Market Crash of 1929 and The Lessons You Must Learn
Other Prominent US Stock Market Crash
You must understand that the stocks operate in a cycle.
There will be swings, crests and troughs.
The point is how well you can gear up for the potential stock market crash and in what way can you line up your investment to capitalize or limit losses.
The horrors of a Black Monday revisited Wall Street again in 1987.
It was another October Monday in 1987.
The Dow slumped over 20% on October 19.
It was the largest single-day loss for the Index till date.
The market took almost 2 years to recover from the losses that were clocked.
Needless to mention that this crash followed a 40% plus up move and yet again it was a story of over-leveraged positions.
But this crash was triggered by three main factors
- The investors were very worried about the Congress perspective on the anti-takeover legislation
- When the US Treasury Secretary announced that he might let the dollar depreciate
- Quantitative trading
Overall, while the first two factors contributed to the initial triggers for this particular US stock market crash and the third factor, quantitative trading, aggravated the losses even further.
1. Major Stock Market Crash in the 1990s
When you consider the major stock market crash in the 1990s there are a few more that need mention.
Perhaps the Dot Com Bubble that crashed in 2000 was one of the most notable ones.
In 1999, the technology stocks were moving up and investor interest further boosted the stock price levels.
But at the turn of the millennium, the Y2K scare took over investor sentiment.
New computers were brought, advanced technologies and software introduced to tackle the difference between 1999 and 2000.
While technology stocks rose up but when the millennium took a turn and eventually the bubble crashed.
Meanwhile, in Asia around that time, 1997, the stock market crash in Hong Kong unveiled another economic crisis, The Asian Financial Crisis.
This was triggered by the long-term capital management crisis. Needless to mention that the aftershocks of this crisis continued for a long while and Asian markets took time to recover from these losses.
2. The 2008 US Stock Market Crash
Perhaps in this context, another prominent US stock market crash is undeniably that of 2008.
Needless to mention this one too triggered a huge economic turmoil and came to be known as the sub-prime crisis.
Perhaps the most poignant image of this crash was ex-Lehman employees walking out of their offices with their box.
An air of gloom, uncertainty and unrest plagued the markets for the four or five years that followed.
In many ways, the global economy is still coming to grips with the impact of the downturn that the 2008 US stock market crash unveiled.
The Dow dropped a massive 700 points on September 29, 2008.
For many, it was almost like living their worst nightmare.
It was the largest intraday point drop by any Index ever on the NYSE.
It was primarily triggered by the failure of the bailout bill in the US Senate.
Lehman Brothers went bankrupt and the markets went on an absolute spin.
Such was the intensity of the downward spiral, the Dow lost almost 50% of its value in the 6-month period that this crisis unraveled.
Apart from these, there have been notable flash crashes too in the market.
The most prominent US stock market crash in this context is undeniably the one that market and investors probably remember the most.
In a matter of minutes, the Dow Jones index slumped over 1000 points.
It was considered to be a fall out of an inexplicable shutdown in quantitative trading as a result of technical failure.
But the sheer volume of the fall created significant ripples across markets and investors globally.
How Does Stock Market Crash Impact You?
So, the most you want to know is how exactly does the stock market crash affect you?
It is possible that you might not have been directly impacted by the immediate crash but inevitably most major stock market crash result in a bear market that could continue for a rather extended period.
Not just that most times stock market crash has resulted into major recessions globally.
The impact of this is never easy to weather.
Whether you want to invest, start a new business or merely look for jobs, recession invariably impacts almost every walk of our economic aspiration.
You must understand while a stock market crash might result in the Index slumping 10-20%, individual stock prices often hit rock bottom levels.
When stock prices are moving higher exponentially, there is always a fear of missing out gains that make investors buy even at stretched levels.
On the contrary when the stock markets crash happens, they are stuck with extremely devalued stocks, panic sets in yet, again and again, they sell at whatever possible levels to get out of those stocks.
So, investors are buying at highs and selling at lows totally defeating the fundamentals of stock market transactions.
The Lessons You Learn from the Stock Market Crash
We can conclude that the stock market crash teaches us the most important lesson of investment.
Make the trend your friend and avoid any panic-driven moves.
You must buy stocks based on their financials and not their emotional value.
Be it the stock market crash of 1929 or any other US stock market crash, they all teach us the important lesson that stretched valuation invariably leads to a stock market crash.
Perhaps keeping a well-diversified portfolio can help you tackle losses during the stock market crash a lot more effectively.