Stock market crashes have far-reaching consequences for both investors and society as a whole. As stock prices plunge, investors’ portfolios lose value, and firms with publicly-traded shares find it more difficult to raise funds.
India and the global markets have witnessed and experienced numerous stock market crashes in the past, where the severity of each crash has been different. For instance, the 2020 Coronavirus stock market crisis only lasted a few months. On the other hand, the 1929 US stock market crash, known as the Great Depression, lasted ten years and was the biggest economic downturn in American history. Equities had lost over 90% of their value by the time it ended.
The Financial Crisis of 2007-08 was another jolt to global economies. It was a result of the collapse of the US housing market and contributed to the Great Recession. The S&P 500 index dropped 51.9% in value, and the Sensex also fell by around 52%.
In India, the Harshad Mehta scam in 1992 caused a crash in the stock market, and the BSE dropped 12.77%. Further, on May 17, 2004, when the UPA held a one-seat majority in the House of Commons, the BSE plunged 15.52%, the largest decrease in its history (in percentage terms).
Stock market crashes have left a major impact on the way investors operate in the market today, as well as on the security and regulatory measures that have developed over time. But what causes these crashes? And what are the repercussions?
Let us look at what a stock market crash is, what causes it, and what you can do in such a situation.
What is a stock market crash?
Different people have different meanings for a share market collapse.
Mostly, people believe that when a stock market index loses more than 10% of its value in a single day, it is a crash. However, a few investors identify a crash as a significant or dramatic loss in the stock market’s value and individual share values over a short period. A stock market crash, in a nutshell, is a dramatic fall in its overall value.
But what causes this significant downturn? Let us have a look at the 9 major factors that lead to a stock market crash.
What are the reasons for a stock market crash?
The 9 major reasons for a stock market crash include:
1. Economic conditions
Inflation, growth prospects, interest rates, unemployment, and exchange rates are all factors that affect the economy. All of these factors also impact the stock market and can be the main reasons for a stock market crash.
If the economy is not doing well, there will be less scope for growth, reducing the activities of companies and thereby causing a decline in their performance. As investors analyse how a particular company is doing before investing in its shares, such a decline can lead to investors losing faith. Such a negative sentiment can trigger a crash in the stock market.
Moreover, rising inflation also prompts a series of actions. Interest rates and inflation have a direct relationship as they are used by the banks as a corrective tool to curb the rising price levels. With increasing inflation, interest rates also soar. As interest rates rise, households have fewer funds to invest in the market, reducing the demand for securities and pushing the stock market down.
Currently, inflation is very high across the globe. You can witness increasing interest rates as well as rising unemployment levels. All these qualify as reasons for the recent stock market crash.
2. Monetary policy
The Government creates and tweaks its monetary policy in order to adjust the money supply in the economy. For instance, during inflation, the Government raises the interest rates as a corrective tool to curb the rising price levels. Thus, with inflation, as prices soar, interest rates soar too. In the past few months, central banks such as the RBI and the Fed have increased interest rates as inflation is on the rise.
As interest rates rise, you will have fewer funds to invest in the market. Consequently, you will reduce your demand for the securities. Just like that, other investors who find themselves in the same situation reduce their demand as well, pushing the stock market down.
Moreover, if interest rates are high, so are the borrowing rates. If businesses cannot borrow freely, they will not be able to expand. The economy will slow if businesses fail.
Before 2008, the Fed cut off its interest rates to beat the recession, but as soon as they started increasing the rates, the housing bubble burst, leading to what we all know as the 2008 global financial crisis. It had a massive negative impact. Not only did the US stock exchanges suffer, but so did the stock markets globally.
3. Global economy
The economies of all countries are interdependent in terms of trade and other financial activities; therefore, they are all affected by global economic conditions.
For example, the Indian market attracts a large amount of international investment, and as a result, global economic developments have an impact on the level of investment in India, resulting in changes in the Indian stock market.
4. Natural/Man-made disasters
Natural as well as man-made disasters are possible causes of a stock market crash. This can include anything from floods to wars, and even pandemics, as we saw in the March 2020 crash when the Covid-19 pandemic caught pace.
As the spread of COVID-19 became more apparent, the economic outlook for India and other countries became increasingly bleak. Companies began safeguarding profit margins through layoffs, while investors began dumping equities as Governments announced travel restrictions, obligatory business shutdowns, and quarantines. This led to a severe drop in major Indian stock indices such as the SENSEX and NIFTY 50 from February to March 2020.
Speculation is when you buy a particular asset or security with the hope that its value will rise and you can make a quick profit by selling it off. When we look at the stock market, speculation is a very common instance. Investors buy securities at low rates and sell them off as soon as they gain value.
Here, investors only focus on the price sensitivity that a security has shown over time and they ignore the fundamentals of the security. Increased interest in a particular sector or asset typically leads to a bubble. Investors put their money in a sector in the hopes of seeing it expand or based on future performance predictions. However, if the performance falls short of expectations and the hype fails to match reality, the bubble bursts and a huge sell-off happens.
With increased selling pressure, the value of the assets keeps falling and may eventually lead to a major market crash. The most popular example of this is the housing bubble that was formed in the US, which led to the stock market crash and the financial crisis of 2008.
6. Geopolitical factors
Stock markets are easily influenced by the happenings around the world. A particular country’s market may be affected by an event in another country. For instance, the Russia-Ukraine war hindered economic activity in India and inflation peaked, negatively affecting the stock market. On February 25, 2022, the day Russia attacked Ukraine, Sensex fell 2702 points, and Nifty ended at 16247, a considerably lower figure than the previous few days.
Not only this, but the war also caused commodity prices to rise. After 2014, crude oil prices hit a record high of over $130 per barrel in March 2022.
7. Excessive leverage
Leverage, which is a way to invest using borrowed money, can be a very useful tool. For instance, you can invest Rs. 10,000 in the stock market using your own funds. If the expected return is 10%, you will make Rs. 1,000 on your investment. However, if you borrow Rs. 10,000 at 3% per annum, and invest a total of Rs. 20,000, you stand to double your profits and earn Rs. 2,000. However, it is not that straightforward. As you will have to pay interest on the borrowed funds, your net returns will be lower than Rs. 2,000. You must calculate your returns at a rate which is the difference between the expected market rate of return and the interest rate on your borrowed funds, which, in this case, will be 7%. Your net returns will be Rs. 1,400.
Leverage, on the other hand, may be perilous when things are not going your way. Excessive leverage can lead to huge losses when things go wrong. In a market correction, if the expected returns are falling, it may be a warning signal for investors paying high interest rates on their loans. To avoid further losses, investors start selling. As prices decrease, businesses and investors that are heavily in debt are forced to sell, lowering prices even further, which could trigger a market crash.
8. FII sell-offs
FIIs are the foreign investment banks, hedge funds, and other big players that invest in the Indian stock market. As they increase their demand and start buying in the market, the prices of securities rise, there is a huge capital inflow, and the market moves up. However, many factors can lead to a fall in their demand, or they may even start selling their holdings. The continued selling by foreign institutional investors (FIIs) can put pressure on the stock market. As they sell, the prices fall. This can lead to a huge loss of value and be the onset of a market crash. Since October 2022, FIIs have been net sellers, selling securities of approximately Rs. 2 lakh crore. This has been a major factor of the bearish trend in the market and can easily trigger a crash.
To know more about the importance of FIIs in the Indian stock market, read our article on FIIs impact on Indian stock market on the Teji Mandi blog.
9. Panic selling
Another prevalent reason for a stock market crash is panic. Stockholders who are concerned that the value of their investments is in jeopardy will sell their shares to preserve their capital; as prices begin to fall, the panic spreads. Without a proper analysis of why the prices are falling, a majority of the investors tend to follow the herd and start selling. This has a domino effect, and the market may eventually crash.
These are the major reasons for a market crash.
As you can see, there are a huge number of factors that affect the performance of a stock market. With so many forces at play, it may be impossible to completely prevent a crash. However, there are ways to mitigate the downfall. Let us see how that is done.
How is a stock market crash controlled?
You cannot prevent the stock market from collapsing. Governments, on the other hand, have established controls to prevent market instability. Circuit breakers are one such approach, introduced in India in 2001. As soon as the regulators of a stock market sense any emergency situation, they activate circuit breakers to prevent markets from collapsing. This can be when market participants start panicking and decide to sell their stocks due to suspicions that they are overvalued. Employing a circuit breaker means that trading is halted for a particular period in the stock exchange. This time frame may be of a few minutes, some hours, or even till the end of a particular trading day.
With many such measures in place, it is vital to know that there is no need to panic and that your investment will be safe in the long term. Here are a few tips to navigate your way through a stock market crash.
What should you do during a stock market crash?
If the stock market plunges, you can do the following things:
- First and foremost, do not sell out because you are panicking. It is challenging to keep your composure as your portfolio’s value plummets. Selling is rarely a winning strategy while prices are declining. Markets tend to revert over time, so selling while shares are low could result in a loss in the long run.
- Keep in mind that price drops might be brief, and prices can swiftly rise. Moreover, you can take the time to analyse good stocks and buy them to profit in the long run.
- Having a solid defensive stock mix in your portfolio is one advanced strategy. Utilities and food, for example, are examples of securities that are less affected by market disruptions. Thus, it is always recommended to have a well-diversified portfolio.
The most important way to safeguard your investments is to have a grip on your emotions during phases of massive market fluctuations. Get more detailed tips to pull through in a stock market crash in our article on ‘how to control your greed in a bull market and gain confidence in a bear market’ on the Teji Mandi blog.
Markets have a natural upward and downward cycle. While stock market crises can be devastating, economies recover. This is a compelling argument for investing in the long term. Building a strong portfolio that can withstand market drops and provide a healthy mix of assets will help you get through the tough times.
Over 10,000 investors trust the experts at Teji Mandi for our portfolio management services. We offer active investing advice and help you build a diverse holding of assets that helps you mitigate losses in phases of stock market turmoil. Reach out to us through our website to get started today!