How a Stock Market Crashes

Background

A stock market crash is a steep, sudden decline in the value of a major index over a period of hours or days, often accompanied by acute panic. There is never a fixed value for a stock other than that reached through the supply and demand of buyers and sellers in the market. As a result, stocks are prone to periods of "irrational exuberance" where they're bid up far beyond reason such as during the tech bubble of the early twenty-first century, and crashes where investors are forced to liquidate regardless of underlying value.

The major factor in all crashes is the expansion and contraction of credit. The extension of credit is like creating money out of thin air, and when too much credit exists, prices inevitably go up since more money is available to purchase the same amount of goods and services. 1929 and 2008 were both preceded by periods of easy credit that created the illusion of prosperity. This, in turn, created complacency and made investors even more willing to borrow. Wealth generated this way, however, eventually produces inflation and, if unchecked, can render a currency virtually worthless. While an economy is growing, however, it is difficult for many to discern between genuine growth and credit-fueled mania.

A stock market crash doesn't usually happen suddenly at the market's peak. Instead, it occurs after the market has fallen considerably as savvy investors cash out their inflated gains amidst signs economic growth will not keep pace with credit creation. Ultimately, the instability of the system becomes obvious and credit creation slows, either through a conscious choice of the banking institutions, or by necessity as banks become unable to lend. What develops is essentially like a run on a bank, with shareholders acting like depositors seeking their cash all at once from an institution that cannot possibly hope to accommodate everyone.

By the time the market actually crashes, investors are no longer selling because stock values are too high, but because cash is relatively scarce and they are forced to liquidate their holdings to meet the demands of creditors. The process accelerates under the sheer volume of sellers attempting to exit the market simultaneously. In fact, the major difference between a bear market and a crash is the speed with which it occurs. Though a bear market has a generally accepted definition of a twenty percent decline in the value of a major index, a crash has no such specific definition. Instead, whereas a bear market is created by a gradual erosion of investor confidence, a stock market is an acute instance of panic, amplified by crowd mentality.

The natural result of a credit contraction is for prices to decline; cash actually becomes more valuable because it can buy more things. Depending on the causes of the crash, it may or may not lead to a bear market in stocks and to significant economic depression. Gradually, often several years after a crash and after painful changes in the real economy, an equilibrium is reached between the amount of goods and services and the amount of available cash and credit, and both can again be expanded to accommodate real economic growth.