Stock market crashes: what are they and is another one coming?

Investors regularly hold their breath while prices fall, with just one question in mind: is this a stock market crash? Equities have taken their fair share of beatings during the pandemic, so let’s look at what defines a stock market crash and whether we can expect another one in the near future.

What is a stock market crash?

A stock market crash is a sudden, and dramatic, decline in stock prices across the majority of a stock market. A huge surge in investors selling their shares pushes the prices down further and further, which can result in large losses, and even lead to a significant bear market or recession.

There’s no set definition of a stock market crash, but typically the market would have to fall by more than 10% from its 52-week high over a few days or even weeks to be considered.

Famous stock market crashes include the 1929 Great Depression, Black Monday 1987, the burst of the 2001 dot-com bubble, the Great Recession of 2008, the 2010 flash crash and the 2020 Covid-19 crash.

To get an idea of the depth of a stock market crash, most traders will watch indices that track the overall market, such as the S&P 500 and Nasdaq 100 in the US, and the FTSE 100 in the UK. When you look at the price chart for an index amid a crash, you’ll see the share price literally nosedive, hence the term ‘crash’.

Here’s an example of the Dow Jones Industrial Average Index in March 2020 when it fell by 37% between February 12 and March 23 – this included some of the worst daily percentage declines in history, such as on March 16 when it fell by 12.9% causing trading to be suspended multiple times.

A market crash.

What causes a stock market crash?

A stock market crash is primarily caused by the combination of falling demand and panic selling. Crashes typically happen at the end of a long bull run, or a bubble, which occurs when investor optimism leads to overvalued share prices. Once investors perceive that an asset has reached its peak value, they’ll start to sell the stock in an attempt to get out before the market falls and they take on extreme losses.

As all market prices are based on the perceived collective value of a company, all it takes is just one large sell order to spark the sell-off and induce panic among other investors. Then before you know it, everyone is trying to sell their stocks and creating the crash they feared.

Will the stock market crash soon?

Talk of an imminent stock market crash has been brought on by speculation that the Federal Reserve will start tapering off its quantitative easing programme – meaning it will be buying fewer assets – and the damage to supply chains caused by the pandemic.

With more government spending, we’ve seen an increase in inflation, which has led to investors being cautious. When interest rates are low, as they have been since the start of the global pandemic, inflation is known to increase – couple this with reduced consumer spending and it could cause a recession. Speculation has therefore increased that the Fed is likely to reduce its QE program to reduce inflation. This can lead to ‘taper tantrums’ which causes share and bond prices to fall.

As for supply chains, car manufacturers were some of the first to take a hit as the shortage of microchips out of Asia caused a decline in production and led to weaker sales. And more recently, we saw a huge spike in petrol prices in the UK after supply issues caused by HGV driver shortages caused panic buying at the pumps.

The S&P 500 has traditionally done poorly in September and October, which has always created concerns that a stock market crash is more likely over those months. However, past performance is not a sure indication of future results.

It’s important to remember that no one is going to be able to 100% predict if the market will crash in 2021, so all you can do is keep monitoring the markets and try not to panic.

What happens if the stock market crashes?

If the stock market crashes, there is usually a lasting impact on the economy, such as a recession. As stocks are a viral source of capital within the economy, corporations may struggle to grow if investment falters. This means that businesses may have to lay off workers, who will then spend less, and the economy will become stagnant.

As we know, stock market crashes also cause significant losses for individual investors. This can happen either as a result of selling their shares when the market has fallen or having bought shares via derivative products. It’s important to remember that corrections are part of the market cycle, and although they can induce panic, prices will often recover over time.

As a result of the damage that can be caused, there are a variety of measures that have been put into place in order to lessen the impact of crashes, such as circuit breakers or trading curbs. These safeguards prevent any trading activity over a set period of time, which is intended to stabilise the market and prevent any further declines.

For example, the New York Stock Exchange will halt trading if the S&P 500 declines in price in the event it hits any of the three circuit breakers set at 7%, 13% or 20%.

Another means of protecting the market is called ‘plunge protection’. This is when large organisations step in and purchase large quantities of shares in the hopes of encouraging individuals to continue investing. This method is less effective, however.

What to do in a stock market crash

What to do in a stock market crash will largely depend on what your strategy is: are you a long-term investor or short-term speculator?

For investors, it can be tempting to panic with the rest of the market and sell. A stock market crash will reach a bottom eventually, at which point it’ll bounce back, and you could regret selling your position and taking on a loss. If you sell, you’ll likely be unable to buy back at a price that would enable you to recoup all your losses.

So, if you can’t sell before the crash – which even the most sophisticated investors fail at – your best bet is to maintain a diversified portfolio at all times. This way, in the event of a sell-off, you haven’t put all your eggs in one basket and will hopefully be able to maintain a level of profit.

You may also want to look at hedging your portfolio. Certain asset classes rise in periods of economic downturn, whether they’re defensive stocks that remain stable throughout market cycles or safe havens, they could provide a way of off-setting your losses. For example, gold is a popular hedge against a stock market crash, as frequently prices rise as investors look for a more stable store of value.

For traders, a stock market crash can be an exciting – but risky – time. Using derivative products enables you to take a position that’s traditionally more difficult: going short. When you short a market, you’ll make a profit if the price declines and a loss of it rises. So, shorting stocks amid a crash can create an avenue of profit for speculators, but in such a volatile and unpredictable environment, you’ll need to make sure your risk management measures are solid.