What are the Causes of Stock Market Crashes?
There is some research on the commonalities of stock market crashes. Scott Nations, author of “A History of the United States in Five Crashes,” states that major stock market declines and modern crashes have included:
- Overvalued market
- Some form of financial engineering or “structuring”
- External factor, often unrelated to the stock market
Understanding an Overvalued Market
In general, the best indicator of how to evaluate the market can be found in the price-to-earnings ratio, or P/E (which is also used to evaluate individual stocks). By dividing the total price of the stock market by the earnings of all companies, you arrive at the price investors are willing to pay for one dollar of earnings or profit. The lower the P/E ratio, the cheaper the stock market is (more reasonably priced).
By examining the historical P/E ratio of the market and comparing it to the current ratio, you can get an idea of the relative valuation of the stock market. For example, on March 13, 2020, the average P/E ratio for the S&P 500 was 15.78 and the current P/E ratio for the S&P 500 was 20.38, indicating it was elevated by 29%.
It is worth noting that, according to the famous global economist John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.” Simply put, the stock market can remain overvalued for an extended period before it corrects itself. Therefore, this alone is not sufficient to predict when a crash will occur.
What is Financial Engineering or “Structuring”?
Looking to the past makes it easy to identify previous financial instruments rather than predicting future catalysts. The stock market crash during the internet era was partly facilitated by the irrational exuberance of investors towards all technology-related stocks. The recent stock market crash in 2008 was due to the mispricing of mortgage-backed securities, which are complex financial products.
Nations suggests that algorithmic trading or illiquid ETF funds could pressurize markets in the future. Alongside an overvalued market and an external factor, these investment products could complete the equation for a stock market crash.
The Catalyst for a Stock Market Crash Can Be Anything
The markets were closed for six days after the September 11 attacks in 2001 in an attempt to avert a stock market crash. Despite this effort, on the first trading day after the attacks, the Dow Jones Industrial Average fell by 684.81 points, or 7.1%, marking the largest daily loss in stock market history at that time.
Other crashes can be linked to disasters in a similar fashion. The stock market crash of 1907 was triggered by the catastrophic earthquake in San Francisco in 1906, while the Black Monday crash in 1987 was partially influenced by the Iran War.
Of course, it’s not always easy to see when a major event will lead to a stock market crash. However, that doesn’t prevent jittery investors from overreacting to an event that could impact the stock market.
How to Prepare for the Next Stock Market Crash
We are in an overvalued market right now. There are enough financial investment products in our markets. However, nobody knows what the catalyst for the next stock market crash will be. But in reality, that doesn’t matter, because you cannot fully prepare for the next stock market crash without completely exiting the investment market. However, you can cushion the blow when the inevitable market crash occurs. Your best bet is diversification: don’t keep all your money in one place like the stock market. Especially as you grow older, consider having other investments, such as bonds and real estate funds, and keeping some cash on hand. That may help to have assets that won’t fail if the market crashes.
And when
You are considering reducing the size of your stock portfolio as the markets are overvalued. Be aware that you might miss some upward opportunities at the moment.
As Keynes briefly hinted, markets can remain irrational and overvalued longer than you can remain solvent. Our recent history bears witness to this fact. Ultimately, when liquidity is impacted by having more sellers than buyers, markets will decrease in value, but when the inevitable stock market crash will happen is a mystery.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts found in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and quality of our content.
Investor.gov. “Price-Earnings (P/E) Ratio.”
Multpl. “S&P 500 PE Ratio.”
Yahoo! Finance. “Dow Jones Industrial Average (^DJI).”
Federal Reserve History. “The Panic of 1907.”
Federal Reserve History. “Stock Market Crash of 1987.”
Source: https://www.thebalancemoney.com/warning-signs-of-next-stock-market-crash-4147361
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