Are you wondering if the stock prices will dramatically fall? Your answer is yes. But the million-dollar question is ‘When will the next stock market crash be?’
Stock markets can crash due to panic selling, breakage of bubbles, along with several economic factors. With the coming U.S. elections, the world under the attack of a pandemic, the Brexit under process, it is bound to crash.
The stock prices like that of Nasdaq and many more are rising by the day. Do you think they will continue to increase? Well, you may be wrong if you think stock prices can touch the sky. Either tomorrow or after a few months, this bubble will break. Unless the biggest player—the Federal Reserve hops in to save the crash.
The Federal Reserve holds power to impact the world economy. If the Fed increases the market liquidity by injecting printed currency, the crash may postpone. However, before knowing how the crash can be stopped, let us know more about why the stock market crash would occur. For this, let’s take a look at the reasons behind the previous stock market crash events.
Why Does the Stock Market Crash?
When the prices of stocks excessively decline (over 10%), the market is likely to crash. It usually results in low liquidity caused due to a noticeable loss in paper wealth in the market. Due to various economic events, some market participants sell off their shares. This leads to more and more sales of stocks resulting in a panic selling.
High-end market indices like Standard & Poor (S&P) and Dow Jones greatly impact the selling and buying of stocks. A sudden fall in such indices may turn investors into sellers, creating a panic in the market. Some of the conditions leading to a crash in the stock market may be:
- A bull market: Constant rise in stock prices over a period
- Price earning ratios going higher than long-term averages
- Economic factors: recession, change in government, big corporate scams
- Other factors: natural disasters, international wars
History
The stock market crash is not a new term. The event has been occurring several times since the inception of this financial market. For dealing with the present-day economic crisis, it is essential to study the causes behind a stock market crash. Moreover, learning about the conditions that lead to a stock market crash can make you ready for such an event.
Here’s a list of a few major events of market collapses, where the market fell by 10% or more.
Tulip Crash, 1634
In 1634, the Dutch elite was mesmerized by the beauty of Tulips, imported from Turkey. The demand for these flowers heightened so much that its prices drastically increased. As the prices rose, so did the investments. The decline of interest in tulips after a few years caused the opposite of what was predicted. Resultantly, speculators were left bankrupt.
The Great Depression of 1929
In October 1929, real-estate and auto industries displayed a wild buying and selling period. Stock market participants invested like crazy in these industries to the extent that many investors borrowed money to purchase stocks. What next? The speculative bubble popped, leaving those over-leveraged investors bankrupt. The crash was so intense that the stock market fell by over 12%.
Black Monday of 1987
The biggest market loss of U.S. history in a single day, Black Monday was driven by leveraged borrowers and technology. Due to high leverages and buyouts, the stock prices boomed, causing a stage of panic selling. The selling was higher and faster due to computer trading. Resultantly, the stock market had fallen by 23% in one day.
This is when the market executives invented circuit breakers to prevent such recurring incidents.
Dotcom Bubble Burst of 2001
With the introduction of internet stocks, the investors’ interest boomed, and companies noticed a significant rise in prices. One such company, Globe.com, raised over $28 million through IPO. Over a few years, investors lost interest in inflated stocks causing Globe.com and many such companies to get delisted by Nasdaq. This led to a decline in Nasdaq from 50000 to 1000 over a year.
The Financial Crisis of 2008
This crisis was fuelled by mortgage-backed securities (MBS). Due to the lack of house-owners paying their mortgage loans, the MBS values dramatically fell. The financial institutions—sellers of MBS to investors and banks, went bankrupt. Only with the financial support of the U.S. Congress and the Federal Reserve did the economy recover after two years.
Present-Day Scenario
Factors responsible for today’s stock market situation:
COVID-19: The biggest factor that has led to the current stock market crisis is the spread of the coronavirus. The markets drastically fell within a few months of its inception. One such indication is the S&P composite falling by 40%. S&P is known to be a measure of Volatility (degree of panic among the market participants).
Oil Price War: Saudi Arabia and Russia are the most extensive global suppliers of oil and gas. The prices of these commodities have been on the drop for several years. However, in March 2020, the start of an economic war among these countries led to a dramatic decrease in oil prices.
The price war affected the stock markets all over the world. The Dow Jones dropped to its lowest in history by over 2000 points. Italy’s stock exchange faced a fall of 17% in its index. The impact on the U.S. stock market was so grave that trading was stopped for 15 minutes. This happened despite the circuit breakers, specially designed to prevent the stock market from crashing.
Other factors: Unemployment is undoubtedly an economic issue faced by most of the countries these days. The U.S has still not recovered from the previous recession. Further, the Fed’s yield curve is a strong inverted one, predicting an incoming recession. What’s more? The corporate world has been facing indebtedness due to the worsening economic climate.
Despite these aspects, many investors believe that the economy will stabilize. This is due to the news of the corona vaccine and the addition of new jobs. However, the jobs are not enough, and the vaccine hasn’t been out yet. Companies are still in debt, and the economies on a downfall.
How Does A Stock Market Crash Affect The Economy?
Influence of Stock Market on Economy
To understand the influence of the stock market crash on an economy, we must first understand the contribution of the stock market in an economy.
Fund for Business: Businesses can easily gain funds from the stock market. This is in the form of (Initial Public Offering). By getting themselves listed on the stock exchange, business owners can sell the stocks of their company to the public.
The advantage of IPOs is that the business gets direct funding to help in its growth. However, the downside of selling stocks is that the founder is no longer the sole owner. The shareholders own a portion of the company. Irrespective of that, founders can keep 51% or more shares of the company to have the ownership control.
Overcome Inflation: Ideally, stock prices go through an increase of about 7% every year (source), including inflation. This helps the stock owners to overcome inflation as opposed to those holding bonds or saving money in bank accounts.
Investment by Small Investors: Due to the existence of stock markets, small and individual investors can easily buy the stocks of the large, successful companies. If it weren’t for these markets, only the big investors and financial institutions could benefit from the economy.
Impact of Stock Market Crash on the Economy
Having learned about the direct influence of stock markets on the economy, let us go ahead to see the effects of a crash.
Investors buy a company’s share with the confidence that the business is bound to be successful in the future. As a business expands, the value of stock prices increases.
A crash or lower stock prices would bring business growth to a halt. Resultantly, companies won’t get enough funds for growth, directly affecting the country’s gross domestic product (GDP). Moreover, new businesses will not get enough investors to buy their stocks, hampering their growth process.
Other than business investment, personal consumption is also a significant component of GDP. The lower value of stocks will also lead to investors going bankrupt. Companies that had purchased stocks will not have enough funds to meet the employee salary and pension fund requirements.
End Game—How to Deal with a Stock Market Crash?
Preventing a Stock Market Crash
- Circuit breakers: In case of a huge decline in stock prices (7% or above), the market closes for 15 minutes or the rest of the day.
- Plunge protection: Buying a large number of stocks by big banks or the Fed. In some cases, government funding.
Preparing for the Stock Market Crash
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- Enter Dollar-cost Averaging: Investing at regular intervals (monthly or quarterly) instead of investing based on intuitions and predictions.
- Invest in high-quality stocks: Purchase stocks of companies that have strong balance sheets and enough liquidity. Such companies can overcome a financial crisis.
- Adopt a long-term strategy: Once the market declines, it is expected to continue that way for a while. However, there are high chances of gain once it recovers.
The government is trying to stabilize the economy by pumping newly printed currency. However, this is only adding up to equities. The money is directly going into the financial bubble. With the increasing market volatility rates, the stock market is bound to hit a full-on crash very soon!