Stock Market Crash

A sharp decline in a particular region's overall stock market at a given time

A stock market crash is a sharp decline in a particular region's overall stock market at a given time.

Stock Market Crash

 It is characterized by a 

  • Period of high uncertainty and 
  • Low public sentiment 
  • It can also trigger panic selling in a market.
  • A crash is generally followed by a bubble, geopolitical instability, or negative news.

It can increase liquidity in the economy as cash is withdrawn from the market. It can also benefit other instrument classes like bonds and commodities like Gold and Silver.

The most notable characteristic of a crash is that it comes at an unanticipated time and it comes suddenly. A collision can last from days to weeks to years to even decades!

A crash is followed by a widespread drop in stock prices, falling benchmarks, low confidence in markets, decreasing liquidity, low sentiments, and volatile market disruptions.

How does the market work?

The stock market is easy to understand but impossibly hard to master kind of tool. The first instances of a market were seen in the 1400s in modern-day Belgium. The first company listed on a stock exchange was the Dutch East India Company. It was traded on the first exchange in Amsterdam in 1611.

In early 1700, the Buttonwood Agreement was formed, eventually leading to the formation of the world's largest stock exchange today: the New York Stock Exchange NYSE.

But it was until the 1790s that the US got its first exchange in the Philadelphia Stock Exchange. It played a crucial role in forming the base for today's well-known US financial system.

Since then, the free trade mechanism has come a long way, today, we have multiple exchanges in almost every big country, and every prominent city has an exchange. 

The market is now closely linked with the economy more than ever, which drives today's economy.NYSE is still the world's biggest exchange in trade value but exchanges in countries like India, Singapore, Hong Kong, South Korea, and China.

Bull and Bear

In this journey, analysts and economists worldwide have developed some theories and bendable rules and regulations concerning the market. 

It is well known that the market works on trade cycles. Trade cycles are frequent cyclical shifts in the state of a country's economy or a region, which can last from 1-2 years to even 10-15 years.

Cycles are often unavoidable and unpredictable. Moreover, there can be cycles of different durations: a cycle can last from one month to one year and even a decade!

Trade cycles are a complex phenomenon, impacting the economy drastically and significantly. Therefore, the stock market is a very vital tool for the economy. It connects people who have money in the economy to other people who need cash in an economy.

In simple words, it is a physical or virtual marketplace where savers and investors invest their money in companies to get returns. It is an effective tool for corporate financing: it makes money from existing cash and grows the economy.

Main Causes of a Stock Market Crash 

Many people think a crash is caused by something big and significant, but that may not always be the case here. There are several other reasons for a crash which are as follows.

1. A Bubble

A bubble is generally an inflated situation where something or some commodity is inflated because of overbuying to an extent where it is not sustainable anymore.

Bubble

When investors and others realize this, that particular commodity's price slumps or crashes due to the panic selling and emergency outflow of funds. 

In the case of a full-fledged economy, this happens when the stock markets and other financial indicators are rising at rapid rates. Still, at the same time, the GDP and other economic indicators are not giving any booming signals. 

This creates a contradictory situation and eventually causes a bubble to crash. The most famous examples of a bubble are the Great Financial Crisis of 2008 and the Dot Com Bubble of 2001.

2. A geopolitical event

A big geopolitical disaster can also set the markets tumbling like wild bushes. 

Markets are closely linked to geopolitical events, and economies are closely tied up nowadays in this globalized world. So any tiny news or event can have rattling impacts on the stock market.

The world is getting more destabilized the day after, which are times of uncertainty. Stock markets do not like uncertainty at all. Any political turmoil in any western country can have a significant impact on stock markets in Hong Kong.

The global supply chain is also an issue.

Suppose, due to some political restrictions, a significant supply provider in the global chain can no longer be a part of it. In that case, this sudden vacuum will create an uproar worldwide, and markets everywhere will come crashing down. 

This is still a very optimistic situation. An example of this can be the terrorist attack of 9/11 on the United States, where markets crashed worldwide. 

Another recent example can be found in the Russia-Ukraine conflict of 2022. The US petrodollar agreement failure it would have gone through would have also led to a significant market crash.

Due to many embargos put by the US on energy supplies from Russia, many countries like China tried using an alternative payment method for global trade as Russia was banned from the SWIFT payments system.

If gone through, this would have resulted in a decline in the value of the US Dollar, as the usability of the US Dollar would have declined, which is the only thing holding the immense value of the dollar right now.

3. Pessimistic future expectations of a global event.

Covid

If market sentiments deteriorate suddenly, it can also lead to a global crash. Yes, a small thing like that can disastrously impact the global economy!

It can be fueled by some global event that carries enormous significance in our daily lives. Moreover, something insignificant can also trigger such chain reactions. 

If some financial institutions have pessimistic views on the global economy, they can also trigger mass panic. These things generally form a chain reaction which is very dangerous for markets.

A recent example of such an event is the spread of the novel coronavirus or the COVID-19 pandemic, which caused the global economy to slow down because of mass lockdowns all over the globe.

Loss of oil reserves, insufficient reserves of gold, exhausting lithium ores, or even poor agricultural produce can trigger such chain events. Natural calamities are also very high on this list of probable dooms due to ever-increasing levels of global warming.

And these are only the global events and causes we have discussed; there can be several, if not infinite, causes of a domestic stock market crash. In addition, changing ruling parties with different views can also lead to a crash.

In short, the market behaves on sentiments and emotions, and anything that can change this can affect the market.

Famous Crashes

The biggest loophole in our financial systems has been our inability to successfully predict and determine the possible countermeasures to a financial crisis.

The words' crisis' and 'recession' have a thin line. A financial recession is characterized by a massive decline in production levels in an economy for a sustained period. A financial recession for a prolonged time is known as a 'Depression.' The best example of depression is 'The Great Depression of 1929'. 

Depression

A Crisis generally follows a recession or depression. 

A crisis is characterized by a decline in the value of money and purchasing power of consumers, the rising cost of production, and a sharp drop in demand and supply.

There is vast unemployment and distrust for the people in power, increased crime rates, and a decline in quality of living are some of the features of a financial crisis.

This section will talk about all the world-famous market crashes that have served as a sample for future research on crashes. All our knowledge of crashes is only obtained from these falls.

The Great Financial Crisis of 2008 or The Real Estate Crash

"If you wait till you know everything, it's too late" - Warren Buffet

The 2008 crisis was mainly due to three reasons:

1. Low rate of borrowing

2. Adjustable Mortgage rates

3. Mortgage-backed securities issued vast amounts by investment banks mainly consist of subprime borrowers.

After the 'dot-com crash' of 2000 and the September attacks of 2001, also known as the '9/11 attacks', the Fed lowered interest rates to almost 1% from previous highs of 5-6%, which made borrowing drastically cheaper. 

It also nudged the small banks to lend out more loans to revive the economy from the two events by increasing demand. 

Also, the 'American Dream' of owning a house was glorified heavily by politicians and media outlets, so people used cheap credit to buy homes in massive amounts. 

Adjustable mortgage rates are mortgage rates that adjust depending on the prevailing market prices. 

Timing

These adjustable-rate mortgages were low because of cheap credit, so banks started lending these mortgages to subprime borrowers, known as 'Subprime loans.' 

These sub-loans are given to high-risk borrowers with a much greater chance of defaulting on the loan, and these borrowers would not get loans under the standard lending system. 

Small banks started issuing loans, which were clubbed together to make a 'mortgage-backed security.' 

These securities were then discounted according to their credit ratings and traded by large investment banks. Large institutional banks buy these mortgages, pay a lump sum price at a slight discount, and then receive the mortgage payments from the borrowers over time. 

The problem struck when these large banks started clubbing the high-risk mortgages with the moderate and low-risk mortgages to get a good credit rating, determining the quality of these securities. 

As all the high-risk mortgages received an AAA rating, considered very safe, banks enjoyed good returns on these securities. Moreover, they co-existed in a housing bubble simultaneously because of the cheap credit, which increased demand. 

Houses

Housing prices in the US rose sharply, as did the number of low adjustable-interest rate mortgages.

When the price reached too high for consumers to sustain, and the Fed raised interest rates, the market borrowing rate increased suddenly, and so did the adjustable-mortgage rates.

Demand for housing decreased, plus the subprime borrowers started defaulting on their mortgages, which lowered their value. In addition, it significantly questioned their liquidity as no one wanted to repurchase them anymore. 

This led to a chain of defaults. First, substantial investment banks started to default on their payments, and many banks could not repay the creditors because of the decrease in value of the mortgage-backed securities. 

This worsened to a point where the fourth largest bank in the USA, Lehman Brothers, a 158-year-old institution with assets worth $600 billion in its peak period, filed for bankruptcy on September 15, 2008, due to decreasing share prices and rising price defaults.

The government and other big institutions saved many other banks; Bear Stearns was bought by JP Morgan Chase, which incurred huge losses. However, the demise of Lehman Brothers caused Wall Street to crash. 

This had an impact worldwide as the investment banks had assets and operated worldwide.

The dot com bubble of 2001

In the early 1990s, the internet became a massive sensation in the US and the western world, especially in the US. People realized the potential of doing things digitally. Innovations were rapidly increasing this hype among the people.

Dot com

Seeing this boom, many new startup lovers started making new companies capitalize on this opportunity. People bought almost anything with a dot com in its name; that was the craze.

Furthermore, people started playing dirty when they realized they could fool uneducated and technologically less unaware people by creating a new company, promising high goals, taking their money, and then running away.

There were more Tech startup IPOs in the United States between 1990 and 2000 than in any other combined sector. As a result, people and investors saw massive gains, two-fold and three-fold returns in months!

This trend overheated to a level where it formed a bubble so big that when it burst in 2001, the prices of tech stocks lost 90% of their value in a fortnight, and most of those new startups were bankrupt and unsustainable.

Ordinary people and retail investors lost their dear money, and the market took almost 2-3 years to recover from its previous lows. Since then, tech stocks have done better, but this crash shows how dangerous a bubble can be.

The Great Depression of 1929

The crash of 1929, which caused a depression worldwide, is a perfect example of what negative public sentiments can do to an economy. 

Before 1929, the US markets had given high returns on investments for almost a decade, and people thought that trend to be eternal for some time.

The Gold Standard crisis led to all the gold being outflowed to the US because of its cheap exports, which declined global currency values and low agricultural procured in Southern Americas and added up to this crash.

Hard times

People were bullish on the market until it reached its saturation point, after which stock prices started to tumble slowly. 

However, it caused widespread panic among the new investors. Finally, the situation became severe enough to let the big institutions participate in this panic selling which led to this crash.

Other reasons for this crash were high unemployment rates and low GDP forecasts. As a result, the US GDP fell almost 30% in the decade after the crash, and the market took nearly 9-10 years to return to its previous levels.

Many people lost their jobs and companies, and many investors lost their life earnings in one fortnight.

Overall it was a very dark phase for the global economy as the US was the only financially well-performing economy.

The global economy tumbled after 1929, and it did not get a chance to recover until the second world war (when the western nations increased production and economic activity). Then, after winning allies, the markets rewarded the people in its style.

Conclusion

Overall, markets are a potent tool and should not be taken lightly. People can benefit a lot from markets. Moreover, both businesses and investors can make money through markets. After all, it connects the two and keeps the economy healthy.

Markets work on a cyclical basis, and there are phases of cycles of economic activity in every economy to which markets react accordingly. Although they may not always be rational, markets can be predicted to a certain extent.

Data

Market crashes or corrections in the leman language are no longer extraordinary, and in these times of uncertainty, one should always be wary of bad situations.

Market crashes are devastating, but markets have always bounced back better on the positive outlook in strong economies with high growth prospects. Markets will continue to perform this way until a significant change happens, which isn't happening anytime soon.

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Researched and authored by Aditya MurarkaLinkedIn

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