Can the Stock Market Crash Again?
Causes of stock market crashes and how to survive them
The stock market crash of 1929 is the benchmark against which all other market declines are measured. That’s because it ushered in the Great Depression and took 25 years to return to pre-crash levels.
Since then, any time the stock market posts a large decline the question arises: "Can it happen again?"
The answer? Probably.
When speculation gets out of control and values rise beyond fundamental metrics, the market will reset. This has happened almost every decade over the past 40 years. There is no specific definition of a stock market crash, but when an index experiences an abrupt double-digit percentage drop, it’s considered a crash. However, market pullbacks are part of the investment cycle. In fact, a pullback of 10% could happen as often as every 16 months or so.
Investors can lower their risk and minimize losses by learning lessons from past crashes, as well as some basic rules for investing, so that they’re prepared for if and when the stock market crashes again.
Past Stock Market Crashes
The Dow Jones Industrial Average and most indexes are measured in points, and significant declines are also measured as a percentage. On Black Monday, Oct. 28, 1929, the Dow tumbled nearly 13%, with a 12% drop the following day, bottoming out three years later 340 points, or 89%, below its peak. Today, 340 points is less than 2% of the Dow's value. However, 340 points back then was a large percentage drop. Percentages give a measurement for easy comparisons.
While it's very unlikely to see a decline of this depth again, other declines have come close.
1929 Trading on Margin
A few of the reasons blamed for the 1929 crash include the Federal Reserve raising interest rates, runs on banks, and excessive speculation. Speculators took out loans to buy stock, called margin, putting down just a percentage of the price. When the market began to fall, banks and brokers called back their loans, forcing speculators to sell, pushing the market even lower.
In the wake of the 1929 crash, the federal government passed a series of laws to regulate markets and protect investors. These laws included the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the Securities and Exchange Commission (SEC). Since then, the government has passed more laws to protect investors.
After the crash, the Fed ruled investors need 50% of the purchase price to use margin, but even that carries a lot of risk. The average investor can learn from history and not borrow to invest.
1987 Technology Issues
In 1987, the Dow peaked on Oct. 1, and then began to fall. It culminated with a one-day crash of 22.6% on Oct. 19, the largest one-day market decline in history and the biggest market downturn since the Great Depression. It took two years to regain its high.
Again, the decline started with the Fed raising interest rates. But the 22.6% crash was partially blamed on computerized trading called program trading. Program trading put something called “portfolio insurance” in place to protect portfolios by selling at a set price. When the shares hit the price, computers flooded the market with sell orders that it was unable to handle, accelerating the decline.
After the 1987 crash, the market instituted circuit breakers to halt trading when the market moved too fast in one direction.
2000 and 2007 Bubbles
In 2000, the dot-com bubble popped. Between February 2000 and September 2002, the Nasdaq Composite Index fell almost 80%, taking over 10 years to recover its losses.
The decline was again the result of excessive speculation. This time, investors bought companies that did not earn profits, pushing valuations to unreasonable heights. The decline started as companies ran out of cash, combined with a ruling that Microsoft was a monopoly and, of course, the Fed raising rates.
The bursting of a housing bubble caused what is commonly known as “the financial crisis,” or Great Recession of 2008. Low interest rates and lax lending standards made it easy for people with poor credit to qualify for subprime loans and buy houses with little to no money down.
Banks took the risky mortgages, turned them into derivatives and sold them to institutions, such as pension funds. The funds also bought credit default swaps as insurance, but when companies couldn't honor the swaps, they fell apart. Then banks stopped lending to each other.
On Sept. 29, 2008, the Dow fell 778 points, or 7%. That decline was sparked by the House of Representatives refusing to pass a bailout to rescue banks and unfreeze the world’s credit markets. This exacerbated the problem, and over the next six months, the index fell 41%. The total decline from its 2007 high was 54%, and it took six years to hit that high again.
2020 Stock Market Crash
On Feb. 12, 2020, the Dow hit an all-time high when it closed at 29,551. Over the next six weeks, the index sank 37% as people panicked over the economic fallout from the COVID-19 pandemic. While pandemics are considered "black swan" events that come around once in a lifetime, stock valuations had been stretched, and the bond market predicted a recession. So, while the catalyst for the crash was unseen, people did see signs that the market could soon fall. After the March 23 low, the market recovered fully before the end of the year.
While it's impossible to foretell or control what the market will do, there’s always the chance that another stock market crash will happen. Average investors should follow a few rules learned from the past stock market crashes in order to weather unpredictable lows:
- Don’t borrow to invest unless you’re a pro and have the means.
- Evaluate your own risk tolerance and set stop-loss orders for individual stocks or ETFs.
- Avoid just following the herd and getting swept up in the next big trends. Research the businesses you are investing in and buy stable companies. Look deeply into what ETFs and mutual funds hold inside them. Sometimes the name isn’t telling the whole story.
- Set goals for what the investment will be used for and time horizons to achieve that. Try to avoid panic and emotion by selling into deep losses. Try to stay invested and not get swept away by the changing tide.