Business, Legal & Accounting Glossary
A stock market crash is a sudden and precipitous drop in the stock market averages.
A swift simultaneous price decline in a large number of securities in a stock market leads to a stock market crash. Such crash generally causes a huge loss of national wealth. There can be several reasons behind a crash such as negative economic or business news or panic. Such crashes may also be the result of overblown speculative bubbles and overleveraging of the markets.
Stock market crashes are generally caused by a herd mentality, where market participants follow each others’ lead in panic sell-off causing prices to slump down dramatically and swiftly. Such crowd behaviour may be triggered by economic news. Analysis of past crashes shows that such meltdowns follow an extended period of irrational exuberance, which causes companies’ PE ratios to explode. This problem is further corroborated by excessive use of leveraging and margin funding which increases the risk profile of market participants.
There is no definitive or numerical definition of a stock market crash, but a market is said to be crashed when it suffers sharp double-digit percentage loss in a single day or over the span of a couple of days. A stock market crash is different from a bear market which may last for months and in most cases for years. In contrast to a bear market, stock market crashes often last for a couple of days only. Stock market crashes may or may not lead to bear market. In the 1990s, the bear market in Japan was not accompanied by any prominent crash. Similarly, the stock market meltdown of 1987 also did not cause a bear market. Though in most of the cases, stock market crashes and bear markets go hand in hand, their relationship is not linear.
Throughout the history of stock markets, there had been several notable crashes. The most prominent one was the Wall Street Crash in 1929. US economy was doing extremely well during the decade and the period had seen major technological innovations such as telephone, power grid, aviation and automobiles and radio. The companies like General Motors and Radio Corporation of America witnessed their stock prices touching new highs. Financial markets were also doing well as banking companies were designing and floating new products like mutual funds promising high returns to investors. Investors were increasingly using debt to finance their stock market activities.
Dow Jones Industrial Average was at 63.9 on August 24, 1921. The index has risen six times to 381.2 as on September 3, 1929. However, by this time it had become apparent that the economy is losing its steam. Stock markets reacted to new circumstances and declined several times during the year. Such declines caused investors to panic and became the cause of Black Thursday and Black Tuesday. Black Thursday occurred on October 24 and Black Tuesday on October 29.
Black Tuesday saw DJIA falling by 380 points or 12.8 per cent. The index closed at 260. The steep decline caused the exchanges’ infrastructure to crumble. Its telegraphs and telephone lines were not able to manage the selling pressure. Such pressure also took its toll on ticker tape used to show the current stock price to investors. Such a breakdown of infrastructure further panicked the investors and deepened the crisis. Market crashes are generally exacerbated by margin funding, leverage trading and mass panic selloffs.
Since investors were heavily leveraged, they were obliged to liquidate their positions on account of margin calls. The exchange was flooded with sell orders. New age stocks saw a massive decline in their stock prices. During the course of two days, the DJIA fell by 23 per cent. By November 11, DJIA had felled by 40 per cent from its September levels. The crash was followed by rallies which provide temporary and false relief to investors and eventually led to even bigger losses. DJIA bottomed out in July 1932. By this time, the exchange had already lost 89 per cent of its worth. This crash led to the worst economic catastrophe of the century in the form of the Great Depression.
Trading curbs or circuit breakers are employed to avert steep falls in the value of a stock. Such curbs lead to a trading stop in the cash market. In response to a crash in the market, trading is also stopped in the derivatives market. Circuit breakers are applied in response to significant movements in the market indicators. Depending on the circumstances, trading halts may be applied to any security, class of security or across the exchange. In some cases, major stock markets can stage coordinated simultaneous trading halt in order to avoid a major crash. These rules are periodically changed according to the changed circumstances.
Different countries have different approaches toward circuit breakers. The United States follows triple tier circuit breakers. For DJIA, the United States have several guidelines. In cases where DJIA breaches its first threshold, a halt is imposed. If the halt occurs before 2 PM then the market is closed down for a period of an hour. If the halt happens between 2 PM and 2:30 PM, then the market is closed for 30 minutes. If the breach occurs after 2:30 PM then no trading halt takes place.
In the case of threshold 2, if the breach occurs before 1 PM, then the market is closed for 2 hours. If the breach happens between 1 PM and 2 PM, the trading is stopped for one hour. If the breach happens after 2 PM, then the market is closed for the rest of the day.
In the case of threshold 3, any breach at any time leads to the closing of the market for the entire day. US regulators determine the threshold levels at the starting of the quarter. Threshold 1 was defined as the drop of 1200 points for the second quarter in 2011. For the same time period, threshold 2 stood at 2400 points and threshold 3 stood at 3600 points. There can also be coordinated trading halts across major exchanges.
France implements daily price restrictions for the cash market as well as the derivatives segment. On the basis of daily transaction volume and the number of securities, different limits are imposed for different securities. For example, more liquid securities have different limits imposed on them in comparison to lesser liquid securities. As an example, if a liquid stock shows movement beyond 10 percent of its previous close, the trading may be stopped for 15 minutes. Once the trading is resumed and the stock price moves beyond 5 per cent limit, another halt of 15 minutes is imposed. This may be repeated once more and in the third occurrence, the trading is stopped for the entire day. Any trading halt in the cash market leads to the simultaneous halt in the derivative market as well. France has also enacted similar rules for CAC40 index. In case, more than 35 per cent of the index’s capitalization cannot be quoted, the calculation for the index is deferred. In such cases, a trend indicator replaces the index. If CAC40 index has less than 25 per cent of its capitalization quoted, then the calculation is deferred for 30 minutes. In case additional deposits are required, the calculation halt extends to an hour.
Stock markets are expected to follow random walk theory. According to conventional wisdom, stock prices behave according to normal distribution. However, in 1963, Benoit Mandelbrot, a celebrated mathematician suggested that stock markets show movements much more drastic than that could happen with a normal distribution. He said that the stock price movements are much more closely aligned to the chaos theory concept and non-linear phenomenon. Mandelbrot suggested that stock prices follow Levy flight instead of random walk theory. Levy flight is a type of random walk with occasional large movements. Gene Stanley and Rosario Mantegna studied over a million records related to S&P 500 market index and calculated the returns for a period of over 5 years. Researchers are now using various computing tools such as simulation to predict crowd behaviour. Researchers are also using mathematical and scientific formulas to quantify and predict stock market meltdowns. Conventionally, it is believed that the stock markets and stock prices follow random Gaussian distribution. However, this belief has been widely challenged now.
Well-known investor George Soros also referred to market reflexivity and its non-linear behaviour. He famously stated, ‘Mr. Robert Prechter’s reversal proved to be the crack that started the avalanche’. Researchers working with Massachusetts Institute of Technology have related the stock market crashes to the inverse cubic power law. According to Prof. Didler Sornette, stock market meltdown shows the existence of self-organized criticality in capital markets. New England Complex Systems Institute researchers have used complexity theory to isolate warning signs for an impending crash. According to this research, such crashed are precede by heightened mimicry in the stock market. Researchers also claimed that each stock market meltdown occurring the past quarter of a century was preceded by a steep increase in the level of market mimicry. Panic is spread easily once investors start following each other closely.
Proceedings of the National Academy of Sciences published a study entitled Switching processes in financial markets showing that general empirical law can be used to quantify stock market performance before crashes. Jim Miekka developed the Hindenburg Omen to forecast market bubbles. Hindenburg Omen is considered to be a controversial market predictor. Recently, a new phenomenon called RR Reversal has been publicized. This phenomenon describes the rapid increase in stock price followed by a sudden and inexplicable contraction in the price by 10 to 40 per cent within the period of a month. The related phenomenon of JJ Jumpstart may be used to avert RR Reversal.
A stock market crash is a sudden and precipitous drop in the stock market averages.
The keywords are sudden and precipitous. In stock market history, there are many short periods of time where the market averages fell precipitously, but none more dramatic or storied than the big two:
Unfortunately, the concept of the “crash” is so ingrained in the fear mechanism of investors that the word is thrown around with little or no meaning anymore. After all, what is a crash? Has the SEC or NASD ever set out to define exactly what constitutes a crash? How does a crash differ from your typical vanilla flavoured decline? To illustrate what is meant by a crash, let’s quote from the Washington Post on the day after the 1987 decline:
The stock market was devastated by the worst one-day collapse in history yesterday in a pandemonium of panic selling that shattered all records and swamped stock exchanges around the country and overseas… John Phelan, chairman of the New York Stock Exchange, called the collapse a near “meltdown” caused by a “confluence” of factors: the market’s inevitable turnaround after its long climb, heightened anxieties over rising interest rates and future inflation, and the impact of computerized trading manoeuvres.
–Washington Post, October 20, 1987
Words like “devastation,” “pandemonium,” and “meltdown,” especially coming out of the mouth of the chairman of the NYSE, should give you an indication of what’s involved in a “crash.” It isn’t pretty and it doesn’t happen often. You see, our language has words to describe various degrees of goodness and badness. “Crash” is really bad and happens once every several generations, if at all. In the past 100 years, we’ve had two such events. That’s about 28,000 trading days, and two of them are called “crashes.” Why then do we constantly contemplate the next debacle? I suppose part of the answer lies in the fact that using exaggeration helps us to cope. I also think that we tend to concentrate all of our collective effort on understanding the incredibly rare occurrence and doing very little to adhere to the obvious and often occurrence. After all, “10,000 planes landed safely today” isn’t much of a headline, is it? I imagine that it’s instructive to understand what causes horrible events so that we may not repeat them, but if I had to choose between understanding what happens twice a century and what happens every day, I’d choose the latter.
The reality is that the market generally rises. On average, the market goes up 10-12% a year. It’s normal for this to happen because the economy grows and profits rise. Profits rise in strong companies and weak companies get parsed out of the picture in a Darwinian fog of natural selection. New companies then start-up and have the audacity to believe that they can compete against the Intel’s, Googles and Microsofts of the world. The beauty is that some actually do, and the entire landscape of our capitalist society becomes stronger for it and we continue to grow.
Will we “crash” tomorrow? The next day? I have no idea and I don’t really care. Given that I don’t have a crystal ball and couldn’t predict it anyway, there isn’t much I’d be able to do about it. All I can do is manage my risk by constantly evaluating the attractiveness of the stocks I own. That’s where the education comes in, the hard work and the satisfaction. So, if I could give any advice, it would be to do your homework, go forward with a belief in our capitalist society, stay invested, and stop worrying about when the next darn Crash is going to happen.
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This glossary post was last updated: 28th November, 2021 | 0 Views.