What Causes a Stock Market Crash?

×
Stock market crash
Getty Images/Image Source
In 1602, the Dutch East India Co. established the Amsterdam Bourse, now recognized as the world's oldest stock exchange. However, it wasn't until 1720 that the first recorded stock market crash occurred. Since then, every investor hoping to time the market has been trying to predict when the next crash will arrive.

Ask a dozen people what causes markets to plummet, and you'll likely get a dozen different responses, many with conspiratorial undertones ranging from government manipulation of central banks to extraterrestrial, mass mind-control experiments.

The real reason markets crash is much less exotic, but understanding the mechanics behind it can help you steer clear of the market at the most dangerous times.

First, let's consider how a normal market operates.

Imagine you own a dress shop that sells frocks in three colors: red, white and blue. When you take your weekly inventory, you find that the red dresses are hot -- you can't keep them in stock -- while the white dresses are selling moderately, and the blue dresses barely at all.

Based on your analysis, you decide to discount the price of the blue dresses to try to get them moving, raise the price of the red dresses to make more profit,
and leave the price of the white ones alone. These are the normal dynamics of supply and demand: Items in high demand cost more, items in low demand cost less.

Now, imagine that after a few weeks you notice that none of your dresses are selling, no matter what the color. At first you think it's just a temporary phenomenon so you discount each color slightly, but a week later you still haven't sold any dresses. Now you start to get a bit panicky and cut prices even more.

Then a news story breaks saying that dresses are out of fashion. Suddenly not only are you trying to discount your dresses heavily, but so are your competitors -- even the factories that make dresses. The price of dresses plunges in a free-fall, or crash. This is exactly how a market crash works -- just substitute individual stocks for the different colored dresses.

In a normal market, prices rise and fall based on supply and demand for individual stocks. But when investors as a group start to close their wallets and sellers can't find buyers, prices will drop more generally. This type of action is typical of a pullback in an otherwise healthy market, but when combined with a negative piece of news or data, it can intensify selling.

If those early rounds of selling cause stocks to breach certain technical indicators,
like the 200-day moving average -- the gauge some large institutions use to define a bull or bear market -- then selling can become widespread and relentless, quickly driving prices down further. And as investors' accounts lose value, those who have bought on margin will often have to liquidate more of their holdings to cover their loses, spurring new waves of selling.

So at the end of the day, crashes happen when there are more sellers in the market than buyers. This imbalance is caused by the perceptions of market participants, and can be based on analysts' estimates, corporate earnings, macro political or economic events, or a thousand other bits of data.

The important thing to remember is that, at some point, it doesn't really matter what the catalyst for the selling is, because as it increases, the mechanics of the markets eventually take over and the trend will continue until it's exhausted. Understanding those mechanics and recognizing them when they begin will help you to step aside in time to avoid the carnage of a market crash.

No man is an island, or even a peninsula, so I encourage your feedback in the comments below. And don't forget to pick up my book, "Trading: The Best of the Best - Top Trading Tips for Our Time" via Amazon.


Are We in a Market Correction?

Increase your money and finance knowledge from home

Income Investing

Grow your nest-egg.

View Course »

Professional Vs Do it Yourself Investing

Should you get advice or DYI?

View Course »

Add a Comment

*0 / 3000 Character Maximum

3 Comments

Filter by:
mkimbley12

Great article! However, if you want some professional stock trading report for free, I suggest you to look at http://vip.marketfy.com/biotech-guide/ Christian Tharp is a true expert!

October 08 2014 at 9:44 AM Report abuse rate up rate down Reply
eteldridges

Thanks. The article helped me understand in a simple way how the market goes up and down.

February 07 2014 at 11:36 AM Report abuse rate up rate down Reply
boowah

Market crashes occur when insider traders decide to create them. After they minipulate the market to go higher, they take their profits and sit on the sidelines until the market falls and creates bargains, which would by ok except they know when the corporations are making moves to increase or decrease their shareholder values. Then they begin buying or selling again.When they make a mistake based on false information, the market crashes.

February 07 2014 at 11:33 AM Report abuse rate up rate down Reply
alfredschrader

Actually, that's not what is happening at all. A significant part of the price of a stock is based on the faith people have in it. If it looks like the company is going to make handsome profits, the share price usually reflects this with higher prices. If it looks the company is a poor performer, then the share price reflects this with lower demand and lower price for it. Sometimes there are nation wide or world wide economic changes that effect the profitability of all corporations. If the news is bad enough, the bottom can fall out of the markets because the result is a sell-off and crash as investors try to "recover" at least part of their investment. A wise investor will diversify into other investments besides stocks to reduce this risk.

There are two values of a stock corporation - the market capital which is the market price of the stock times the number of shares outstanding, and the book value of the corporation. The book value is the value of the land, buildings, inventory, and equipment owned by the corporation less any money they owe.
Right now the market capital of most corporations is higher than the book value, but for a time during the 1980's it was reverse. There were many corporations that had a much higher book value than market cap value. For example one corp might have had a share price of $10.00 but the land, buildings, inventory, and equipment was worth $20.00 a share. If you borrowed money, and bought all of the shares from investors, you could sell-off the LBIE, pay the loan back, and make a nice profit. The biggest one of these I had approved was $1.2 billion.
This worked so well that we did it to my own corporation.

February 07 2014 at 11:24 AM Report abuse rate up rate down Reply
wpoulson

Although you outline the main reasons that drive a stock market collapse, you fail to shed light on the impact computers contribute to stock market crashes. The algorithms that are programmed into institutional brokerage firms contain the same calculations you have mentioned but unlike a manual system, when they fire off, they generate"panic" on a scale not commensurate with the actual economic environment.

February 07 2014 at 11:23 AM Report abuse rate up rate down Reply