The next stock market crash could easily kick-start a recession, and the underlying reason is that stocks are shares of ownership in a corporation. As a result, the stock market reflects investors' confidence in the future earnings of all the companies in it. Corporate earnings are dependent on the health of the U.S. economy, and that makes the stock market a leading economic indicator for the U.S. economy itself.
- Stock market crashes can reduce business financing and consumer confidence, both of which can cause recessions.
- These types of crashes typically occur after periods of irrational exuberance, when investors stop caring about whether a stock's price accurately reflects the company's value.
- Crashes don't always lead to recessions, especially when the government steps in to cushion the blow on key segments of the economy.
- Panic selling is one of the worst ways an individual can react to a market crash.
Effects of Market Crashes
A crash signals a massive loss of confidence in the economy, and when that confidence is not restored, it leads to a recession. A crash also frightens consumers into buying less. That's a huge hit to the economy, since consumer spending is the largest component (70%) of gross domestic product (GDP).
A crash also means less financing for new businesses, as the sale of stocks provides companies the funds they need to grow.
Lastly, a declining U.S stock market slows global economic growth. First, it will cause the other stock indexes to decline, although a recession might not follow a crash right away. For example, in the first quarter of 2007, the Dow Jones Industrial Average fell more than 600 points in a week, but it recovered during the year and rose to a high of 14,000 in October. Although the crash did not cause a recession itself, it did signal that one was coming.
When a Crash Doesn't Lead to a Recession
One way to avoid a recession following a crash is when the Federal Reserve can restore confidence in the market. One good example is the stock market crash of 1987, also called "Black Monday." On October 19, the Dow dropped by 22.61%. It was the largest one-day percentage drop in stock market history. Investors panicked over the impact of anti-takeover legislation moving through Congress, and the bill would have eliminated the tax deduction for loans used to finance corporate takeovers. Computerized stock trading programs made the sell-off worse, so the Fed immediately started pumping money into banks. As a result, the market stabilized.
When Will the Next Stock Market Crash Occur?
The next serious crash is most likely to occur after a bout of irrational exuberance. That's when investors are so confident that stock prices will keep going up they lose sight of underlying values. It only happens during the later expansion phase of the business cycle, when the economy has been running at full capacity for a while, maybe even years. This means that there aren't many undiscovered investment opportunities.
As a result, investors try to outperform the market, searching for any overlooked profit, and sink more money into investments with poor returns. Without solid fundamentals, they follow each other into whatever is rising, which creates an asset bubble. When the bubble bursts, the stock market crashes. If it crashes enough, it can create a recession.
Examples of a Stock Market Crash
You can learn about when stock market crashes have caused recessions by studying the history of recessions.
2008: The Great Recession
On September 15, 2008, the Dow dropped 500 points—the worst drop since the bottom of the 2001 recession.
U.S. Treasury Secretary Henry Paulson didn't bail out Lehman Brothers, which threw the markets into a crisis of confidence. Financial companies knew that they would be forced to eat the losses they had sustained from the subprime mortgage crisis.
As the value of these financial companies' stocks fell, they knew that they would have a hard time raising new capital to cover their losses and make new loans. In this way, the stock market decline threatened to put these banks out of business if they didn't have sufficient reserves to cover the downturn. That, in and of itself, could have put the economy into a bona fide recession.
On October 5, 2008, the Dow fell from over 10,000 to below 8,500, a 15% decline in one week. It signaled a sudden and extreme loss of confidence in both the market and the underlying economy. It also triggered the Great Recession of 2008.
1929: From Recession to Depression
The worst example to date is the stock market crash of 1929, which occurred over four trading days. It began on Black Thursday (October 24), continued on to Black Monday (October 28), and lasted until Black Tuesday (October 29). During those four days, the stock market lost all of the gains it had made during the entire year.
The sell-off didn't cause the Great Depression by itself. The timeline of the Great Depression shows that a recession had already begun in August, but the crash destroyed confidence in business investing. Banks had used their depositors' money to invest on Wall Street. People who had never even bought a single stock lost their life savings.
When people found out, they rushed to take out their deposits, but for most it was too late. Banks closed over the weekend, and many never reopened. The economy sank into a 10-year depression. The stock market didn't fully recover until 1954.
2001: The Dot-Com Bust
The 2001 recession was largely the result of the Y2K scare. The Year 2000 tech scramble began when tech gurus erroneously predicted that computer software wouldn’t be able to tell the difference between the years 1900 and 2000. That resulted in an abnormal spike in demand for Y2K-compliant hardware and software and, consequently, in exuberant investing in dot-com businesses.
By the time the year 2000 rolled in, most companies had bought what they needed. Sales dropped dramatically, and the dot-com boom became a bust. Many high-tech companies declared bankruptcy.
The high-tech stock market crash was exacerbated by the 9/11 attack in 2001. The Federal Reserve’s high-interest rates also worsened the U.S. economy so by March 2001, the United States entered into an eight-month-long economic slump. The recession ended after President George W. Bush signed a tax relief bill, the Federal Reserve lowered rates, and the government increased spending through its War on Afghanistan.
1987: The Highest One-Day Loss
Other past stock market crashes were also significant but did not cause recessions right away. 1987’s Black Monday recorded the highest one-day percentage loss when the Dow dipped by 20.7%.
1997: The Long-Term Capital Management Crisis
The 1997 Asian financial crisis also affected the stock market and helped to trigger the Long-Term Capital Management crisis. Although the Fed’s bail-out strategy may have averted a global financial catastrophe, it's handling of the LTCM crisis set the precedent for its bailout role in the 2008 financial crisis.
2018: The Biggest Point Loss to Date
In February 2018, the Dow experienced the biggest point loss in history at that time with a drop of 2,270.96 points. It recovered within the next few days, so it was more of a market correction than a crash. Still, some investors were worried about the effect on the markets of the burgeoning national debt and high-interest rates.
2020: The Pandemic Effect
The 2020 stock market crash began on March 9. The Dow Jones Industrial Average set three record point-loss drops within a week. On March 9, it fell 2,013.76 points to 23,851.02, a 7.79% drop. On March 12, it fell a record 2,352.60 points to close at 21,200.62. It was a 9.99% drop, almost a correction in a single day. On March 16, the Dow lost 2,997.10 points to close at 20,188.52.
Prior to the 2020 crash, the Dow had just reached its record high of 29,551.42 on February 12. From that peak to the March 16 low, the DJIA lost 9,362.90 points, or 31.7%. It surpassed the 20% decline that signaled the start of a bear market.
How a Crash Affects You
What should you do to protect yourself? First off, don't panic. The bottom of a bear market has huge swings and volatility. That turns into panic and doom-and-gloom predictions from economists. A recession does not necessarily a depression make. There is always economic growth in other parts of the world. The only way to tell whether a stock market crash is causing a recession is to closely follow economic indicators.