Why Does the Stock Market Crash?

February 2018 has been a bad month for the United States stock market. In just two consecutive trading days, the market crashed by more than 1500 points. As a result, all the incremental gains that were made in January 2018 were simply wiped out within these two days. It would be incorrect to say that the fall in markets came as a surprise to anybody. The market had been extremely bullish for the past few months. It had reached new heights which were earlier thought to be impossible. Hence, there were many skeptics in the stock market who believed that downfall was just around the corner. They also believed that only a catalyst incident was required which would then unleash the pent-up supply and cause a market crash.

In this article, we will have try and understand the common catalyst events that ultimately lead to a downfall in the stock market prices.

Crash vs. Correction

Before we begin our analysis, it is essential to differentiate between a crash and a usual correction. Every small downfall in the equity markets cannot be termed as a crash. A crash happens suddenly and the magnitude is higher. Hence, if the stock market value drops by double digits in a matter of days, it can be called a crash. However, if there is a gradual reduction spread out over several days and even weeks, then it cannot be called a crash. The correct term to use would be “market correction”

Common Factors That Cause Market Crash

  • Interest Rate Hikes: Equity markets have an old saying that “Bull markets do not die of old age. Instead, they are killed by interest rate hikes”. This is particularly true of equity markets in America. The inverse relationship between stock market valuations and interest rates is apparent from the data. After the 2001 dot-com crisis, interest rates were kept at near zero levels to stimulate demand. This led to the formation of a massive asset bubble which burst in 2008 during the subprime mortgage crisis. After the subprime mortgage crisis, the government has once again adopted a loose monetary policy. The low-interest rates and quantitative easing have created an unprecedented bubble. The market is now afraid that the gains are unsustainable and will be soon lost to an interest rate hike.

    As a result, when the data from the economic survey showed that wages had started rising, it spooked the financial markets. Rising wages are considered to be indicators of inflation. Hence, the market assumed that the Fed would raise the interest rates very soon. This led to the massive fall in the Dow Jones index.

  • Taxation: Markets do not like taxation. Capital naturally flows to the investments where it can get the maximum return. Taxation reduces the return earned and as a result, leads to a flight of capital from the market. This is what has happened in the Indian stock market. The Finance Minister of India has introduced a new tax on the profit earned from equities. Ever since this tax was introduced the market started rapidly falling in value. The increase in the interest rate along with the reduced earnings from equities makes market investments considerably less attractive.
  • Stretched Valuations: Another obvious indicator of a coming stock market crash is stretched valuation. If the valuation of companies has been growing at a rapid speed as compared to the underlying fundamentals, a correction is always lurking around the corner. It was claimed that this was the situation in almost all the equity markets around the globe. The price to earnings ratios in all markets were at record highs indicating that prices were growing faster than earnings.
  • Geopolitical Events: The markets also know that political tensions do not work well for business. As a result, whenever there is a major political event like the Gulf war or the 9/11 attack, the markets immediately collapse. The effect on the stock market depends upon the relationship between the two warring countries and whether any strategic commodities are involved. For instance, if a war were to be declared between American and China, the effect would be far greater. This is because both these countries make up a major component of the global trade. Also, both these countries are highly dependent upon each other. War would disrupt this symbiotic relationship leading to business losses. Hence, the stock market collapses in anticipation of such losses.
  • Algorithmic Trading: This is a relatively new phenomenon. With the advent of new technology, big companies do not employ humans to do their trading. Instead, this task is now being done by robots preprogrammed with algorithms. The problem is that since robots are machines, they are still prone to errors. As a result, these robots have led to massive selloffs in the past. Once the downfall starts, a self-perpetuating cycle begins, and market crashes occur.

As an investor, it is necessary to ensure that an eye is kept on the above-mentioned parameters. These events do not happen suddenly. Instead, they just appear to happen suddenly when in reality the trouble is brewing for a long time before the bubble finally bursts.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.

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