Category: Crashes and bubbles

The most recent stock market crash occurred in 2020 as COVID-19 spread worldwide. During the week of Feb. 24, the Dow Jones and S&P 500 tumbled 11% and 12%, respectively, marking the biggest weekly declines to occur since the financial crisis of 2008. The Dow would go on to decline by 9.99% on March 12 — its largest one-day drop since Black Monday of 1987 — followed by an even deeper plunge of 12.9% on March 16.

However, unlike prior crashes whose recoveries required years, the stock market rebounded back to its pre-pandemic peak by May of 2020. Fueling that rapid recovery was an enormous amount of stimulus money, with the Federal Reserve slashing interest rates and injecting $1.5 trillion into money markets and Congress passing a $2.2 trillion aid package at the end of March.

In 1999, the Federal National Mortgage Association (FNMA or Fannie Mae) wanted to make home loans more accessible to those with low credit ratings and less money to spend on down payments than lenders typically required. These subprime borrowers, as they were called, were offered mortgages with payment terms, such as high interest rates and variable payment schedules, that reflected their elevated risk profiles.

This increased availability of mortgage debt appealed to both previously ineligible borrowers and investors, fueling explosive growth in mortgage originations and home sales. At the same time, consumers, many of them new homeowners, took on additional debt to buy other goods. Companies seeking to capitalize on the opportunities afforded by the surging economy also heavily indebted themselves. Financial institutions, similarly, used cheap debt to boost the returns on their investments.

This debt-fueled stock market started to show signs of impending collapse in March, 2007, when the investment bank Bear Stearns could not cover its losses linked to subprime mortgages. Bear Stearns’ failure was not enough by itself to cause the stock market to crash — it kept rising, to 14,164 points on Oct. 9, 2007 — but by September of 2008, the major stock indexes had lost nearly 20% of their value. The Dow didn’t reach its lowest point, which was 54% below its peak, until March 6, 2009. It then took four years for the Dow to fully recover from the crash.

During the late 1990s, the values of internet-based stocks rose sharply. As a result, the technology-dominated NASDAQ Composite Index (NASDAQINDEX: ^IXIC) surged from 1,000 points in 1995 to more than 5,000 in 2000. But in early 2001, the dot-com stock bubble started to burst. The NASDAQ peaked at 5,048.62 points on March 10. The index would go on to plummet by 76.81% until it reached a low of 1,139.90 points on Oct. 4, 2002.

The primary cause of this crash was overvalued internet stocks. Many investors speculated that dot-com companies, even those without revenues, would one day become extremely profitable. As a result, they poured money into the sector, driving up the valuation of every company with “dot com” in its name. This stock market bubble burst when the Federal Reserve tightened its monetary policy, constraining the flow of capital. The NASDAQ did not again rise to its 2001 peak until almost 15 years later.

On Monday, Oct. 19, 1987, the Dow Jones Industrial Average plunged by nearly 22%. Black Monday, as the day is now known, marks the biggest single-day decline in stock market history. The remainder of the month wasn’t much better; by the start of November, 1987, most of the major stock market indexes had lost more than 20% of their value.

No single event caused the stock market to crash in 1987. Instead, a series of factors drove the sell-off, including a widening U.S. trade deficit, computerized trading, and tensions in the Middle East. The rise of program trading, which occurs when computers make automated trades, likely played the biggest role in this crash. The computers tended to produce more buy orders when prices were rising and more sell orders when prices fell. As those sell orders flooded the market on Oct. 19, it caused other investors to sell in a panic.

Because the Black Monday crash was caused primarily by programmatic trading rather than an economic problem, the stock market recovered relatively quickly. The Dow started rebounding in November, 1987, and recouped all its losses by September of 1989.

The worst stock market crash in history started in 1929 and was one of the catalysts of the Great Depression. The crash abruptly ended a period known as the Roaring Twenties, during which the economy expanded significantly and the stock market boomed.

The Dow Jones Industrial Average (DJINDICES:^DJI) rose from 63 points in August, 1921, to 381 points by September of 1929 — a six-fold increase. It started to descend from its peak on Sept. 3, before accelerating during a two-day crash on Monday, Oct. 28, and Tuesday, Oct. 29. The Dow on what is now known as Black Monday tumbled by nearly 13% and declined by another almost 12% on what is referred to as Black Tuesday.

By mid-November, 1929, the Dow had lost about half its value. The stock market was bearish, meaning that its value had declined by more than 20%. The Dow continued to lose value until the summer of 1932, when it bottomed out at 41 points, a stomach-churning 89% below its peak. The Dow didn’t regain its pre-crash value until 1954.

The primary cause of the 1929 stock market crash was excessive leverage. Many individual investors and investment trusts had begun buying stocks on margin, meaning that they paid only 10% of the value of a stock to acquire it under the terms of a margin loan. The investment trusts also often purchased shares of other highly leveraged investment trusts, making the trusts’ fates highly intertwined. Consumers, too, increasingly purchased items on credit. When the debt bubble burst, it caused the greatest stock market and economic crash in modern history.

Markets can also be stabilized by large entities purchasing massive quantities of stocks, essentially setting an example for individual traders and curbing panic selling. In one famous example, the Panic of 1907, a 50% drop in stocks in New York set off a financial panic that threatened to bring down the financial system. J. P. Morgan, the famous financier and investor, convinced New York bankers to step in and use their personal and institutional capital to shore up markets. However, these methods are not always effective, and are unproven.

Circuit Breakers

Since the crashes of 1929 and 1987, safeguards have been put in place to prevent crashes due to panicked stockholders selling their assets. Such safeguards include trading curbs, or circuit breakers, which prevent any trade activity whatsoever for a certain period of time following a sharp decline in stock prices, in hopes of stabilizing the market and preventing it from falling further.

For example, the New York Stock Exchange (NYSE) has a set of thresholds in place to guard against crashes. They provide for trading halts in all equities and options markets during a severe market decline as measured by a single-day decline in the S&P 500 Index. According to the NYSE:

A market-wide trading halt can be triggered if the S&P 500 Index declines in price as compared to the prior day’s closing price of that index.

The triggers have been set by the markets at three circuit breaker thresholds—7% (Level 1), 13% (Level 2), and 20% (Level 3).

A market decline that triggers a Level 1 or Level 2 circuit breaker after 9:30 a.m. ET and before 3:25 p.m. ET will halt market-wide trading for 15 minutes, while a similar market decline at or after 3:25 p.m. ET will not halt market-wide trading.

A market decline that triggers a Level 3 circuit breaker, at any time during the trading day, will halt market-wide trading for the remainder of the trading day.

Although there is no specific threshold for stock market crashes, they are generally considered as abrupt double-digit percentage drop in a stock index over the course of a few days. Stock market crashes often make a significant impact on the economy. Selling shares after a sudden drop in prices and buying too many stocks on margin prior to one are two of the most common ways investors can to lose money when the market crashes.

Well-known U.S. stock market crashes include the market crash of 1929, which resulted from economic decline and panic selling and sparked the Great Depression, and Black Monday (1987), which was also largely caused by investor panic.

Another major crash occurred in 2008 in the housing and real estate market and resulted in what we now refer to as the Great Recession. High-frequency trading was determined to be a cause of the flash crash that occurred in May 2010 and wiped off trillions of dollars from stock prices.

In March 2020, stock markets around the world declined into bear market territory because of the emergence of a pandemic of the COVID-19 coronavirus.

A stock market crash is a rapid and often unanticipated drop in stock prices. A stock market crash can be a side effect of a major catastrophic event, economic crisis, or the collapse of a long-term speculative bubble. Reactionary public panic about a stock market crash can also be a major contributor to it, inducing panic selling that depresses prices even further.

Famous stock market crashes include those during the 1929 Great Depression, Black Monday of 1987, the 2001 dotcom bubble burst, the 2008 financial crisis, and during the 2020 COVID-19 pandemic.

KEY TAKEAWAYS

• A stock market crash is an abrupt drop in stock prices, which may trigger a prolonged bear market or signal economic trouble ahead.
• Market crashes can be made worse be fear in the market and herd behavior among panicked investors to sell.
• Several measures have been put in place to prevent stock market crashes, including circuit breakers and