How Does the Stock Market Crash?

Posted by admin on March 26, 2010 at 7:22 pm · Under Stock Market

With the very recent stock market crash of 2008, there’s hardly anybody who’s oblivious to the impact such a phenomenon causes on the global economy. Almost everywhere you go, you get to hear about the irreparable damage that has been caused on an international as well as on private levels. History has been a witness to several other famous or rather infamous stock market crashes, such as, Wall Street crash of 1929, the Stock Market Crash of 1973-74, Black Monday of 1987 and the Dotcom Bubble of 2000.

Now, to answer the very important question of what actually triggers a stock market crash. Stock market crash can be defined as a phenomenal decline in the stock prices across a wide section of the stock market. Crashes are usually triggered by panic. Other economic factors can also cause the stock market to crash. A few factors often associated with a stock market crash are a considerable period of rising stock prices along with too much of economic optimism, a market situation in which price to earnings ratio exceed long-term averages and also extensive use of market debt and leverages by market participants.

Market crash is specifically associated with human psychology and mass movement. It is a sort of cycle that repeats itself over and over again. Psychology spells that people love bull markets and in a rising market even the words of so-called common market specialist acquires wisdom and get to be valued greatly. This widespread optimism gradually gives way to absolute pessimism and it is exactly at such points that market crashes occur.

Let’s have a look at the cycle and let’s begin from the stage when the market has reached its lowest most point. This is the time when the market is said to be weak and the general population is thoroughly pessimistic. The market is now said to be undervalued and poses a good time for savvy investors or the smart money group to buy stocks so that they can sell them at much higher prices later on. This smart money buying over a period of time causes the stock price to rise. Rising stock will now lure mutual fund investments and billions of dollars start flowing into the market. Markets thus show steady rise powered by mutual fund and other big-time investors. Smart money already starts seeing substantial growth.

This is the time when the retail investors enter to play their assigned role. This group is often the uneducated and uninformed majority who invest on the basis of rumors and articles in financial magazines, the general prevalent market sentiments and the views of so-called market specialists. The general optimism takes the market forward and stock prices double and triple. Under the prevailing market situation many small investors wisely sell and make big-time profits. Their success stories further boost the market. And it is at this point that smart money starts selling because they know that their undervalued stocks will once more drop in value. To add to the complexity the investors start using margin or leverage to accelerate gains. The market is already overbought with the mutual fund and retail investors fully invested.

Under such volatile situations even a hint of negative news will bring down the market like a pack of cards. The market collapses as cash stops flowing in and tumbles down even furiously than it had risen. A situation occurs when everybody is eager to sell and there isn’t anybody willing to buy. Bankruptcy prevails widely. The stocks get undervalued once more and ushers in a new cycle. And it’s once more time for smart money to accumulate stocks, thus foreboding another market crash in the years to come.

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