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Stock market crash

A stock market crash is a financial term you need to know. Bankrate explains.

What is a stock market crash?

Volatility is a fact of life in the stock market. Prices of individual equities and broader indices rise and fall, day in and day out, and markets see turbulent fluctuations over both the near term and the long term. A stock market crash is when a broad index or many related indices experience rapid, double-digit declines. There is no specific percentage decline that precisely defines a stock market crash — unlike bull and bear markets — but participants generally know one when they see one.

Deeper definition

Stock market crashes are driven by crowd dynamics as much as developments in the real economy. Typically, crashes signal the bursting of a speculative bubble or happen after catastrophic events. In either case, stock market participants begin panic selling in an effort to liquidate paper assets like stocks and bonds. Selling begets more selling as markets are flooded with assets, and prices collapse.

Other factors that cause stock market crashes include a prolonged period of rising stock prices and excessive economic optimism, a market where P/E ratios exceed long-term averages, and extensive use of leverage by participants. Economic recessions or even depressions can be touched off by major stock market crashes.

Stock market crashes have widespread implications for both investors and society at large. Investors see the value of their portfolios decline as asset prices collapse, while publically traded corporations see their stock values plummet, making it more difficult for them to raise funds. Retirement plans lose money, causing widespread insecurity. The main indirect effects of these factors are job losses and reduced levels of disposable income in a society.

Crashes require central banks such as the U.S. Federal Reserve to take extraordinary measures to restore normal market functions. Central banks typically reduce interest rates, halt trading or adjust normal market rules, and provide liquidity to markets, specifically to the financial sector. After a crash, lawmakers are often compelled to enact reforms to address the underlying economic factors that led to the crash.

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Stock market crash examples

There have been three major stock market crashes in U.S. markets over the last century, with major implications for the economy and broader society.

1929 crash

In the wake of World War I, the U.S. saw unprecedented prosperity as industrialization swept across the nation, bringing well-paying jobs and affordable consumer goods to a broad swath of the working and middle classes. Concurrently, the stock market attracted many first-time, inexperienced investors who believed that corporate earnings would only increase as the public continued to earn and spend money.

Many new market participants invested in stocks with borrowed money. Investment bankers and brokers took advantage of the market’s newfound popularity and manipulated the market by trading between themselves to artificially raise the value of stocks. When the market started to correct itself, stock prices dropped and panic ensued.

Stock values began falling in early September of 1929. On Oct. 28, 1929, the market dropped 12.8 percent and fell an additional 12 percent the following day, marking the official crash of 1929 and the beginning of what became known as Great Depression.

1987 crash

The stock market expanded steadily through the 1980s, driven by economic recovery from a recession early in the decade, low interest rates, and the rapidly expanding computer industry. Stock valuations had become stretched as forward earnings estimates fell, and the bull market got well ahead of the real economy.

By 1987, funds and major investors had begun adopting computerized trading programs for the first time. However, the systems had never faced broad market sell-offs, and poor assumptions in their design significantly contributed to the crash. On Black Monday — October 19, 1987 — stock markets around the world crashed, with losses compounded by trading programs. The Dow Jones Industrial Average (DJIA) fell 22.6 percent, or 508 points, to 1,738.7, its single biggest one-day decline ever.

2008 crash

Fueled by a growing housing market and recovery from the dot-com bust, the stock market posted steady gains during the mid-2000s. Banks were approving increasing numbers of subprime loans, including a significant number of interest-only and negative amortization loans. Financial institutions bundled the loans into mortgage-backed securities, which were sold to investors as safe, highly rated investments.

As the Fed increased interest rates to cool off the economy and address the housing bubble, subprime borrowers started to default on their mortgages, and widespread investments into MBS spread contagion throughout the economy. Global stock markets gradually sank throughout 2008, precipitating the failure of Lehman Brothers, the investment bank, on September 14th, 2008. On Monday, September 29th, the DJIA dropped 777.7 points, or 6.98 percent, its largest one-day point decline in history (but only the 17th-largest percentage drop).

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