Stock Market Crash Definition
A stock market crash happens when the prices of stocks fall rapidly and in significantly, usually across a wide range of companies and industries. This sudden drop can result in huge financial losses for investors, triggering panic.. Stock market crashes are often caused by a combination of factors like economic instability, risky trading strategies (e.g. CDO, Leveraged ETFs), investor panic, or the bursting of financial bubbles.
Timeline of Major Stock Market Crashes
- The Stock Market Crash of 1929 – The Great Depression: The most infamous crash, the stock market plummeted on October 29, 1929, known as Black Tuesday. This crash led to the Great Depression, with the market losing nearly 90% of its value over the next few years.
- 1987 – Black Monday: On October 19, 1987, the stock market dropped by over 22% in a single day, trigger a stock market crash. This crash was triggered by a combination of high stock valuations and computer-driven trading strategies.
- 2000-2002 – Dot-Com Bubble Burst: The late 1990s saw a massive boom in internet-based companies, but by March 2000, the bubble burst, leading to a market crash that lasted until 2002. Companies with little to no profit went bankrupt, and investors lost trillions of dollars. Companies like eToys.com, Pets.com, and WebVan, a grocery delivery company; burned through capital because of high marketing costs and immature business models.
- 2008 – Global Financial Crisis: Triggered by the collapse of the housing bubble and risky lending practices, the market began to crash in September 2008. Major financial institutions failed, leading to widespread panic and a global recession.
- 2020 – COVID-19 Pandemic: The stock market experienced a rapid decline in March 2020 as the coronavirus pandemic spread worldwide. The market quickly rebounded later in the year, but the crash highlighted the volatility and uncertainty in the market during global crises.
How a Stock Market Crash is Determined
- Magnitude of Decline: A crash usually involves a decline of at least 10% to 20% in major stock indices, such as the Dow Jones Industrial Average (DJIA) or the S&P 500, within a short period—often a few days to a few weeks. Normally, 10% is already considered correction territory for most major stock indexes.
- Speed of the Drop: Unlike regular market corrections, which are gradual, a crash is characterized by a rapid decline in prices. This swift movement is driven by panic selling, where investors rush to sell off assets, fearing further losses. Additionally, those investors using computer aided algorithms to sell also stoke the speed of the drop. Computers will use a complex set of criteria to execute transitions very quickly.
- Market Breadth: The crash affects a wide range of stocks and sectors, not just isolated companies. When a broad spectrum of the market is impacted, it indicates a more systemic issue rather than problems with individual companies.
- Investor Panic: A defining feature of a crash is panic among investors, leading to a cascade of sell-offs. This panic can be triggered by events such as economic data releases, geopolitical tensions, or sudden changes in market conditions.
- Economic Impact: Crashes often signal or lead to broader economic downturns. Although, the stock market may have crashed or be in correction territory, does not mean we are headed in to an economic downturn. The rapid loss of wealth can reduce consumer and business confidence, potentially leading to reduced spending, investment, and even a recession.
What Policies were Enacted to Prevent Stock Market Crashes
- Trading Halts or Circuit Breakers – Circuit breakers are mechanisms that temporarily halt trading on stock exchanges if the market experiences a significant drop in a short period. This pause allows traders to absorb information, prevent panic selling, and stabilize the market. The thresholds for halting trading vary, typically triggering when the market falls by 7%, 13%, or 20% in a single day.
- Sarbanes-Oxley Act of 2002 – This act aimed to enhance corporate governance and strengthen the accuracy and reliability of corporate disclosures.
- Dodd-Frank Protection Act – This act introduced significant financial reforms to reduce risks in the financial system. It established the Financial Stability Oversight Council (FSOC) to monitor systemic risks, created the Consumer Financial Protection Bureau (CFPB) to protect consumers from abusive financial practices.