Stock market crashes are an unfortunate fact of life on Wall Street, with eight major market crashes in the past 100 years, led by the stock market crash of 1929. That stock market crash triggered the Great Depression -- often cited as the worst economic period in U.S. history.
Stock market crashes occur after significant and rapid declines in the stock market over a short period of time -- even in one day, in some cases. Any one-day market decline of 10% or more in a single day is generally described as a market crash.
A steep market decline on a key index, like the Dow Jones Industrial Average or the Standard & Poor's 500, is usually followed by panic selling by investors, sending the stock market into a deeper spiral.
When legions of investors try to sell, that causes further panic in the markets, and can lead to investment companies issuing "margin calls" -- calling in money lent to investors so they can buy stocks and funds -- which forces those investors to sell at current (usually low) prices to get their cash reserves to satisfactory levels to meet those demands. Over the decades, many investors have gone bust over stock market crashes --when supply trumps demand and there are more sellers than buyers.
The numbers following a major market crash are indicative of the seriousness surrounding crash. After the stock market crash of 1929, for example, the U.S. stock market lost 83% of its value over the next three years, pushing many millionaires to join soup lines.
What Happens When the Stock Market Crashes?
Stock market crashes lead to highly negative outcomes for investors, with the following potential consequences:
- A market collapse can wipe out what economists call "paper wealth." Paper wealth is money tied up in investments like the stock market or the real estate market that could be sold for a gain, but hasn't yet. In contrast, "real wealth" refers to actual, physical assets, like the money in your bank account, or a vehicle you own that is fully paid off and can be sold for a definite financial gain.
- Market collapses can really hurt older investors. A stock market collapse can inflict damage across the board, demographically, but the impact on older Americans is especially onerous. Think of a 67-year-old retiree whose assets are largely tied up in the stock market: The value of those assets plummets after a market crash. While a 25-year-old has plenty of time to rebuild portfolio assets, a 67-year-old does not, and doesn't have the needed income any longer to even play "catch up" in the stock market.
- Unemployment jumps after a market crash. Companies invest in the stock market, too -- often heavily. When the market crashes, companies invariably suffer a significant loss to the bottom line, and begin cutting costs and laying off employees to stave off financial disaster. That has a direct impact on the nation's employment figures.
- Banks go bust. Banks and credit unions, the largest lenders in the U.S., often can't recoup their loans after a prolonged market crash and a resulting recession and depression. Many banks, especially smaller ones with higher loan risk, often go belly up after a stock market crash.
- The real estate market turns downward. Homeowners and commercial property owners often suffer severe financial loss after a stock market crash (like the loss of a job or significantly reduced demand for housing.) That scenario picks up steam and causes demand for new homes and apartments to fall, even as property owners may suddenly be unable to afford their loan payments, leading to property foreclosures and personal bankruptcies.
Why Stock Market Crashes Occur: Bull Markets, Bear Markets and Bubbles
Stock market crashes usually come at a time when the economy is overheated -when inflation is growing, when market speculation is high, when market "bubbles" dangerously expand, and when there is strong uncertainty over the direction of the U.S. economy.
In these conditions, stock market crashes often start with a trickle, and soon turn into a raging flood as anxiety-stricken investors look for a quick stock market exit ramp. The problem is that millions of other investors turn their blinkers on and converge on that exit too, creating a major, market-driven traffic jam.
Stock market crashes occur at that unique, but formidable intersection of bull markets, bear markets, and stock market bubbles. When they merge, they can crash in unfortunate ways.
A bull market -- just like the one the U.S. stock market has experienced since 2009 -- happens when investors are optimistic about the markets and the economy, and when demand outpaces supply, thus driving up share prices. As bull markets peter out -- they can last anywhere from two years to nine years -- all it takes is a significant market event to create a crisis of confidence among investors and draw more sellers into the market. This can create a stock market crash that leads to a bear market.
A bear market evolves, often after a stock market crash, when investors grow pessimistic about the stock market, and as share prices fall as supply begins to outpace demand. Economists usually refer to a bear market as the result of the stock market losing 20% of its value over a 52-week period. They usually last about four years, although many don't last even that long. Historically, bear markets are a great time to buy stocks, as prices are low and value is high, and that's exactly what smart investors do.
Stock market bubble
A stock market bubble inflates and explodes when investors, acting in a herd mentality, tend to buy stocks en masse, leading to inflated and unrealistically high market prices. In describing market bubbles, former U.S. Reserve Chair Alan Greenspan referred to investors' "irrational exuberance" on the stock market in 1996, although his prophecy didn't really ring true, as the stock market continued to grow before entering into bear market territory in 2000. A stock market bubble's "pop" is often a signal that the stock market is experiencing a crash over the short-term, and is shifting from bull-to-bear-market mode over the long-term.
What to Do During (and After) a Stock Market Crash
Job one in the midst of a stock market crash is to be aware of your own exposure to the market. Are you highly leveraged as a margin investor? Is your investment portfolio overly weighted with riskier growth stocks or other more-speculative stocks? Has your personal financial situation changed significantly over the course of a 24-hour market collapse?
On Wall Street, the best offense is a good defense, so it's worth taking a "deep dive" into your portfolio, ideally with the help of a credentialed investment professional, while markets are flying high and you don't have to make any snap decisions on portfolio allocations.
Once you've determined you're bruised, but not beaten, by a stock market crash, take these action steps going forward:
- Take no action at all. If you have a good portfolio plan in place, the smartest move to make in a tough market environment is to stay the course. The worst thing you can do is to jump out of the stock market. That's because the chances are you'll still be on the sidelines when the market picks up again. That's called "market timing" and even professional traders usually can't figure out when stocks will rise again. By remaining in the market you'll be assured of being there when the market rebounds -- as it always does, historically.
- Adjust accordingly. If you have to take some course of action, change the stocks you're buying. Historically, some stock sectors do better than others in declining markets. For example, high-dividend stocks tend to be less volatile than other stocks. They are usually insulated from big bear market drops due to the dividend alone. Sector-wise, utility stocks, consumer cyclicals, service-oriented companies, food and pharmaceutical stocks tend to do better during an economic downturn than other companies. Some stock sectors just tend to outperform others during a bear market. The bad news is that when the market does turn bearish again these stocks won't rise as fast and as high as, say, technology or emerging market stocks.
- Spread your risk. Having a well-designed mix of investments is a great idea anytime, but especially so in a down market. That's because you don't take a pounding by having all your eggs in one potentially leaky basket. Studies show that holding a judicious mix of growth and value stocks, possibly in international as well as U.S. companies, and some bonds and cash investments too, is a great way to minimize investment loss.
- Buy when others sell. Historically, stocks rebound much higher than their price levels just before a bear market. This was the case in 1987, 1990, 2001, and in 2008 (just after the Great Recession began) after severe market collapses in those years. By contributing regularly to your 401k plan, your IRA plan and your stock and mutual fund investments, you're "buying at the dip," as Wall Street traders like to say. That means you're buying when prices are low, thus giving you significantly more bang for your investment buck. Remember, stocks become overpriced as bull markets mature. They become cheap in bear markets.
- Take a fixed-income route. If market downturns are keeping you up at night, get conservative and buy bonds and/or bond funds. U.S. Treasury Bonds and money market bonds are usually good options in this scenario. Just remember that by doing so you risk being on the sidelines when the stock market rebounds.
Also, if you don't already have one, consider consulting a financial advisor for tips on surviving a stock market crash, and a resulting bear market. Usually, the first consultation is free.
Above all, stay calm. Bear markets tend to dissipate fairly quickly and bull markets last a lot longer. Think about that before you do anything rash with your investment portfolio after a stock market crash.
Lehman Brothers and Stock Market Crashes
With the 10-year anniversary of the Lehman Brothers bankruptcy this September -- one of the largest investment banking firm collapses in U.S. history -- it is worth reviewing how much of a trigger the Lehman debacle was in the 2008 stock market crash.
The Lehman experience was certainly a key contributor to the steep market decline investors saw that year, and it all had to do with market leverage -- and market realities.
A year before its demise, Lehman's leverage ratio was a massive 30-to-1, which economists consider as being an extremely high risk. The investment banking giant had $22 billion in equity to back $691 billion in total assets. At that point, even a minuscule drop in asset value of 3% was enough to send one of Wall Street's giants careening into oblivion.
Lehman represented the very definition of "high leverage," and basically took that definition and steered it to dangerously high levels. While traditional investment banking giants like JP Morgan (JPM - Get Report) and Wells Fargo (WFC - Get Report) funded their overall business with steady, dependable customer deposits, Lehman took another, riskier route.
It used a hodge-podge menu of about $150 billion in short- and long-term debt, and $180 billion in repurchase, or "repo" agreements, as collateral on short-term repo loans. Once investors began doubting the quality of the collateral Lehman was using, they largely stopped allowing the company to roll over the repo loans into the next 24-hour period, and began asking for their money back -- in full.
That led to Lehman going bankrupt -- and provided a historic and painful lesson to other companies of the danger of high financial leverage, and how it can often contribute to stock market crashes.