What is a Stock Market Crash?
A stock market crash is a rapid and steep decline of stock prices that happens unexpectedly. While there is no defined numerical figure, a typical stock market crash will result in losses of over 10% within a couple of days, as measured by major stock indices, such as the S&P 500, NASDAQ, and the DJIA. While the term ‘crash’ certainly inspires fear among investors, it is important to understand that they are a natural occurrence in the markets, and they happen fairly frequently.
To put this into context: there have been 38 officially documented market corrections in the S&P 500 since 1950. That is an average of every 1.84 years, with a correction defined as a dip of at least 10% off recent closing highs. Out of these market corrections, at least 9 have been categorised as official bear markets, with dips in excess of 20% off highs. This averages out to a bear market every 7.78 years.
But how long do they last?
Out of the 38 market corrections of the S&P 500 since 1950, about 63% have lasted a maximum of 3.5 months, with another 18% of them taking up to 10 months to find a bottom. This means that over 80% of market corrections have lasted less than 1 year. While market corrections are talked about in a matter of months, bull markets are usually considered in terms of years. This is why it is important to point out that practically every documented market correction of the S&P 500 has eventually been wiped out by the succeeding bull market rally. Even factoring all those market corrections/crashes, the S&P 500 has historically averaged annual returns of 7%. So, while any stock market crash is scary in the short term, in hindsight, they are all great opportunities for the long-term investor.
Most Famous Stock Market Crashes in Recent History
As mentioned, stock market crashes are not isolated events in history. There are plenty of them, and they all teach investors valuable lessons. Here are some of the most notable stock market crashes in history:
- The 1637 Tulip Craze. This is one of the most documented stock market crashes, where tulip bulbs were considered a rare commodity, with prices rising to as much as 10 times the average wage of a decent worker. Prices of tulip bulbs crashed as people started buying them on credit, and to this date, the term ‘tulipmania’ is symbolic of the dangers of human greed.
- The South Sea Bubble of 1720. Founded in 1711, The South Sea Company was to enter the lucrative slave trade business in the Central and South American regions. Shares of the company were taken up by both the UK government and the public, but what initially seemed a money-spinning business failed to live up to its billing, and shares that were previously inflated collapsed, shedding off more than 82% of investor wealth.
- The Stock Market Crash of 1873. After the US civil war, railroad construction boomed in the US, with over 35,000 miles of track laid between 1865 and 1873. When major bank Jay Cooke and Company collapsed in 1873, citing, among other reasons, its inability to market railroad debt bonds, panic gripped the market, and the resulting economic downturn almost collapsed the railroad sector, then the highest non-agricultural employer in the country.
- The Panic of 1907. This panic took place within 3 weeks in October 1907, and it resulted in the NYSE tumbling over 50% off its previous year’s highs. A failed bid to corner a major Copper company was the trigger, but it trickled down to contract market liquidity and inspire depositor distrust in financial institutions.
- Wall Street Crash of 1929. After a period of positive speculation that was dubbed as the ‘roaring twenties’, it all came down to a halt on the Black Tuesday of October 29th, 1929, when stock prices collapsed, and over 16 million shares were traded. This crash signalled the start of the Great Depression, and it wasn’t until 1954 that stock prices returned to pre-depression highs.
- ‘Black Monday’ Crash of 1987. On October 19th, 1987 (referred to as ‘Black Monday’), the US Dow Jones Industrial Average tumbled over 22% in a single day (the biggest drop ever). This is considered the first contemporary market crash, triggered by aggressive computer-driven trading models, investor panic, and portfolio insurance strategy.
- Japanese Asset Bubble Burst of 1992. An economic bubble in Japan, between 1986 and 1991, saw stock and real estate prices wildly inflated. Easy credit and rampant speculation drove prices higher, but the bubble popped in 1992, and it was only after 2008 that prices started rising again.
- Asia Financial Crisis of 1997. Triggered by Thailand’s decision to no longer peg its local currency to the US dollar (USD), a series of currency devaluations quickly spread across to its neighbours and managed to successfully destabilise the Asian economy as well as the entire global financial markets.
- Dot-Com Bubble Burst of 2000. The dot-com bubble occurred during a period of excessive speculation of internet-related stocks. The NASDAQ rose fivefold between 1995 and 2000, but by 2002, markets had plunged over 78%, giving back all the gains made during the bubble and resulting in the closure of several internet start-up companies.
- Subprime Mortgage Crisis of 2007-08. Cheap credit and lenient lending conditions led to the collapse of the US housing market. The trickle effects were massive and led to the collapse of an age-old investment bank (Lehman Brothers), which consequently triggered the Great Recession, the worst economic downturn since the 1929 Great Depression.
- The Flash Crash 2010. The May 6th, 2010 flash crash lasted only about 36 minutes, but it managed to wipe out over $1 trillion in value. The flash crash was caused by high-frequency trading algorithms, but the markets quickly recovered the losses.
- 2015-16 Chinese Markets Crash. After a period of excessive speculation, the retail-dominated Chinese stock market became overvalued and inflated, with prices rising due to momentum rather than hard fundamentals. The bubble burst in June 2015, and the markets lost over 30% of their value within 3 weeks. The slump continued until February 2016.
- The COVID-19 Crash of 2020. After a decade of prosperity, post the 2008 Great Recession, a global health pandemic (coronavirus) inspired governments to institute lockdown and curfew restrictions that literally shut down economies. The DJIA plunged over 26% in just 4 days in March 2020 as a result. Despite this, markets recovered later that year.
What Causes Stock Market Crashes?
Investor panic is the major cause of stock market crashes. There is always a fundamental trigger that causes a selloff, such as the coronavirus in 2020 and the collapse of Lehman Brothers in 2008, but it is investor panic that eventually upgrades the selloff to a stock market crash. Generally, stock market crashes occur after a period of extended bull runs. At this point, fears of a recession or economic downturn are exaggerated by sellers who liquidate their assets in complete panic mode.
In more recent stock market crashes though, it is the use of high-frequency computer trading that has been the source of panic in the markets. Algorithms can collectively pick up on emerging trends and execute aggressive sell orders. As this goes on, algorithms that are programmed to trade momentum-based strategies can join in on the action and accelerate the selloff, turning it into a market crash. This was the case during the 2010 Flash Crash described above.
What Are the Effects of Stock Market Crashes?
Stock market crashes can lead to a bear market, which can accelerate into a full-blown economic recession. A bear market occurs when stocks fall beyond the 10% correction into 20% or worse. Bear markets are characterized by negative investor sentiment and overall pessimism on the future of corporations. While bear markets are cyclical, prolonged cases can lead to economic recessions.
Stocks are an important source of capital for corporations. The prices of stocks traded publicly also serve as public validators of the underlying companies. As stock prices decline, the growth of underlying companies is hindered. This can lead to layoffs, unemployment rates rising, consumer spending decreasing, and the economy finally contracting. Stock market crashes that have led to recessions in the past include the 2008 Great Recession and the 1929 Great Depression.
Will the Stock Market Crash Again?
The answer to this question is: Probably! Stock market corrections are an inevitability. Like the economy, stock prices move in cycles. Speculation activity is almost always bound to get out of control because market participants are largely controlled by emotions like greed and fear. If stock valuations experience periods of boom that are driven by speculation and not hard fundamentals, markets are bound to correct to fair values. These corrections can sometimes be overextended such that they degenerate into market crashes. Systemic risks can also trigger market crashes, and it is very difficult to detect them unless they eventually reveal themselves, often when it is too late.
It is almost a fact that a market crash will eventually happen in the future – they happen periodically. But current fundamentals mean that it will be a few more years before we have to deal with another one. Markets have just recovered from the shocks delivered by the 2020 global coronavirus pandemic. Industries that were previously shut down are opening up, and economic activity is picking up fast as vaccination continues throughout the world. At the time of writing (May 2021), conditions are lining up for a period of economic boom, at least from a fundamental point of view.
What Should You Do During A Stock Market Crash?
It is very difficult to predict when a stock market crash will occur. But when it does, there are some dos and don’ts that can help you minimize the impact it will have on your portfolio. A contrarian approach would be to sell before the crash actually begins.
But this is extremely difficult to pull off because no one knows how far bullish markets can extend. But a clue would be to sell when everyone else is greedy and looking to join the bullish party. This would be an indication that emotions are the driving factor rather than company fundamentals.
A conservative approach, though, is to resist the temptation to sell. If your portfolio has a quality selection, you will need to exercise patience to ride out the crash. Although painful, statistics should give you confidence. Over 80% of market crashes have hit rock bottom within 10 months and the losses eventually recovered by successive bullish rallies. The idea though is to have a quality selection of stocks because it is quality companies that have the capability of not only surviving but also thriving during challenging periods. It is also important to actively rebalance your portfolio depending on prevailing market conditions. This will ultimately mean that during a stock market crash, you will be best placed to pick out lucrative stocks at a lower price.
If you wish to absorb risk during periods of stock market crashes, it can also be a prudent idea to buy gold. This yellow metal has been a reliable hedge against stock market crashes. This, however, should be done carefully because prices of the metal can start retreating lower when the market crash bottoms out.
At AvaTrade, we do not provide investment, tax, or financial advice. The information contained in this article is purely educational and informational; and does not take into account your risk tolerance, investment goals, or financial circumstances. All manner of financial investment carries some risks. Please make sure you are up to date with the risks and rewards you are exposed to before making any investment decisions.