Stock market crashes are rare, but nothing new. Most famous are the huge one-day crashes of 1929 and 1987 and more recently, the train wreck that was the GFC in 2007-8.
While the exact cause of each of these crashes can get a bit complicated, stock market crashes are generally caused by some combination of speculation, leverage, and several other key factors.
Here’s a rundown of five different stock market crash catalysts that could contribute to the next plunge in the market.
Many stock market crashes can be blamed on rampant speculation. The Crash of 1929 was a speculative bubble in stocks in general. The crash in tech stocks in the early 2000s followed a period of irrational speculation in dot-com companies. And the crash of 2008 can be attributed to investor speculation in US real estate (and banks enabling the practice).
The point is that when irrational euphoria about a certain asset class or industry exists, it’s not uncommon for it to end very badly.
2. Excessive leverage
When things are going well, leverage (a.k.a. “borrowed money”) can seem like an excellent tool. For example, if I buy $5,000 worth of stock and it rises by 20 per cent, I made $1,000. If I borrow an additional $5,000 and bought $10,000 worth of the same stock, I’d make $2,000, doubling my profits.
On the other hand, when things move against you, leverage can be downright dangerous. Let’s say that my same $5,000 stock investment dropped by 50 per cent. It would sting, but I’d still have $2,500. If I had borrowed an additional $5,000, a 50 per cent drop would wipe me out completely.
Excessive leverage can create a downward spiral in stocks when things turn sour. As prices drop, firms and investors with lots of leverage are forced to sell, which in turn drives prices down even further. The most notable occasion was the Crash of 1929, in which excessive purchasing of stocks on margin played a major role.
3. Interest rates and inflation
Generally speaking, rising interest rates are a negative catalyst for stocks and the economy in general.
This is especially true for income-focused stocks, such as infrastructure companies like Sydney Airport (ASX:SYD). Investors buy these stocks specifically for their dividend yields, and rising market interest rates put downward pressure on these stocks.
As a simplified illustration, if interest rates are 3 per cent and a company 6 per cent, it may seem worth the extra risk to income-seeking investors to choose the stock.
On the other hand, if interest rates jump to 4 per cent, the company’s dividend will (roughly) need to rise proportionally to attract investors. And lower stock prices translate to higher dividend yields, on a percentage basis.
From an economic standpoint, higher interest rates mean higher borrowing costs, which tends to slow down purchasing activity, which can in turn cause stocks to dive.
4. Political risks
While nobody has a crystal ball that can predict the future, it’s a safe bet that the stock market wouldn’t like it much if the U.S. went to war with, say, North Korea.
Markets like stability, and wars and political risk represent the exact opposite. For instance, the Dow Jones Industrial Average dropped by more than 7 per cent during the first trading session following the Sept. 11, 2001, terror attacks, as the uncertainty surrounding the attacks and the next moves spooked investors.
It’s important to point out that stock market crashes aren’t generally caused by one or more of these factors all by themselves. It’s typically a combination of a negative catalyst and investor panic that causes a sharp dive in the stock market.
For example, the steepest market drop during the GFC occurred during September and October 2008. Yes, it was US real estate speculation and excessive leverage that led to the trouble, but fears that the U.S. banking system could potentially collapse sent investors into a panic, which led to the actual crash.
Some combination of these factors
To be clear, this isn’t an exhaustive list of things that could potentially cause a stock market crash.
And it’s likely that more than one of these factors could combine to cause a crash. The 2008 crash, for one, was primarily caused by excessive speculation that caused a bubble in US real estate prices, along with excessive leverage taken on by both consumers and financial institutions, as well as investor panic after banks started to fail.