How Does a Stock Market Crash Occur?

A stock market crash occurs when shareholders look to dump their holdings of stock, shifting prices down. It can be bad for investors that hold stock, although there are ways to make money from a crash if you can predict it in advance. A market crash can happen for a variety of reasons, including bad economic news, other bad news such as war or a terrorist attack or simply a general sense that the economy is overinflated.

Tip

When stock prices go down as shareholders dump their stock holdings, this can lead to a stock market crash. Causes include an overinflated economy, disasters and other bad news events.

Understanding Stock Market Terminology

A stock market crash is a large and generally rapid decline in stock market prices. There isn't a formal definition of a stock market crash, but it's generally understood to mean that prices of stocks in the major indexes, like the Dow Jones Industrial Average or S&P 500, drop by double-digit percentage points in a matter of days or weeks.

A stock market correction is a term often used in connection with crashes. It has a more formal definition: It's a drop of at least 10 percent in the price of a stock or index off its most recent peak price point.

Similarly, a bear market refers to a drop of at least 20 percent off peak prices. The opposite of a bear market is a bull market, where prices of a stock or set of stocks rise at least 20 percent off a recent low.

Distinguishing Depressions and Recessions

A market crash is often associated with the possibility of an economic recession, but recessions aren't directly related to the stock market. A recession in the United States usually means at least two significant quarters with declining gross domestic product.

A depression is a particularly bad recession, but there's not a standard definition for when a recession is or is not a depression. Many economists consider the last U.S. depression to be the Great Depression of the 1930s.

The 1929 Market Crash

The most famous market crash in U.S. history was probably the crash of 1929, culminating in a steep drop on Oct. 29, 1929, known as Black Tuesday. The stock market lost billions of dollars in value, and the stock price drops impacted not only individual investors but also companies and even banks that had invested in the market. That, in turn, cost some people their savings or their jobs.

Prior to the crash, the prices were growing rapidly, and some considered them to be a sort of over-inflated asset bubble. There were also some struggles within the agricultural sector, although they were relatively minor compared to what would come with the Dust Bowl of the 1930s. Many investors had also bought stocks on margin, using borrowed money to do so and had little room for error if the market fell. Once the stock market began to stumble, press coverage and investor panic helped it plummet further and also led to panicked withdrawals, endangering those institutions as well.

Under the New Deal, President Franklin Delano Roosevelt's reform program of the 1930s, bank deposit insurance was created through the Federal Deposit Insurance Corp. to protect depositors in case of bank failures and the Securities and Exchange Commission was created to regulate the markets.

The 1973-1974 Market Crash

Another well-known market crash came in the 1970s, leading into what at the time was the worst bear market since the 1930s. Beginning in October 1973, the Dow Jones Industrial Average fell some 21 percent in about six weeks.

The causes included inflation, which President Richard Nixon struggled to keep in check through a series of wage and price control programs, and anxiety over tensions in the Middle East around the Yom Kippur War between Israel and its Arab neighbors. When several Arab countries launched an embargo banning oil exports to the United States, fuel shortages swept the nation, heightening investor anxiety.

Nixon's troubled presidency didn't help matters, and the market continued to fall in 1974 even after he resigned, letting Vice President Gerald Ford come into office.

The Dot-Com Bubble Burst

During the late 1990s, investors recognizing the value of the nascent World Wide Web bid up the prices of the stocks of many early internet companies, leading the tech-heavy Nasdaq index to rise from 1,000 to 5,000 between 1995 and 2000 alone.

Unfortunately, many of these so-called dot-com companies failed to reach profitability. Some were betting on technology that was still too slow or unreliable to find commercial acceptance, some failed to reach critical mass on an internet that was still relatively small compared to today, and others had unique issues of their own.

Around March 2000, investors recognizing issues with market fundamentals began to sell off the stock of tech companies big and small, leading to panic stock market sales that soon took the market down 10 percent. The bubble burst pulled down a number of high-flying dot-com companies, although the tech sector would later rise again as companies such as Apple, Amazon, Google and Facebook proved important to the economy.

The Sept. 11 Market Crash

Shortly after the dot-com bubble burst, the stock market was brought down again by surprise news of a different sort: the Sept. 11, 2001, terrorist attack on the World Trade Center and the Pentagon.

Markets remained closed for several days following the attack, and when they reopened, prices quickly began to drop, bringing the Dow Jones Industrial Average down more than 14 percent in the first week of trading. Airline stocks and stocks of insurers were particularly badly hit as investors anticipated passengers would shy away from flying and that insurance companies would see terror-related claims rise. Stocks of some companies, such as defense contractors and telecommunications companies, rose.

The 2008 Financial Crisis

In the early to mid-2000s, investors began to sound the alarm that banks and mortgage companies had issued large loans to homeowners who couldn't continue to make payments on them, risking sending their properties into foreclosure and costing investors big money. By late 2008, these predictions began to come true, bringing down big financial institutions like Lehman Brothers, Bear Stearns and lender Washington Mutual and sending the stock market plummeting.

The SEC even instituted a temporary restriction on short-selling financial companies, the process where investors borrow a stock, sell it an anticipate buying it back for a lower price to sell to the original owner.

Understanding Flash Crashes

There have been several events in the last 20 years referred to as flash crashes. This term is generally used to refer to a situation where automated trading software detects abnormal drops in stock prices and quickly begins to dump stock to avoid racking up steep losses.

By automatically dumping stocks, the algorithms essentially create a self-fulfilling prophecy. This has led stock exchanges to put in provisions known as circuit breakers, designed to automatically halt trading in stocks when they block more than a particular percentage in a certain period of time.

Profiting from Crashes

If you correctly anticipate that a stock or the market at large is going to fall, you can make money. If you own stock that is up from the price you bought it, you can sell it for a gain.

You can also sell stock short, though keep in mind that you may end up having to buy it back at a higher price if your guess about the market's direction is wrong. Talk to your brokerage if you're interested in selling stock short.

You can also make a similar bet on a stock's price drop by selling call options, which allow someone to call for delivery of the stock at a specified price at a specified date. If the stock falls below the specified value, called the stock price, the option won't get utilized and you essentially get free money. Of course, if the price rises, you will be on the hook for delivering the stock at the lower price, meaning you lose money.

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About the Author

Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.


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