Stock market crash
Overview
 
A stock market crash is a sudden dramatic decline of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

 prices across a significant cross-section of a stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

, resulting in a significant loss of paper wealth
Paper wealth
Paper wealth means wealth as measured by monetary value, as reflected in the price of assets – how much money one's assets could be sold for. Paper wealth is contrasted with real wealth, which refers to one's actual physical assets....

. Crashes are driven by panic
Panic
Panic is a sudden sensation of fear which is so strong as to dominate or prevent reason and logical thinking, replacing it with overwhelming feelings of anxiety and frantic agitation consistent with an animalistic fight-or-flight reaction...

 as much as by underlying economic factors. They often follow speculative
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...

 stock market bubble
Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....

s.

Stock market crashes are social phenomena
Social phenomenon
Social phenomena include all behavior which influences or is influenced by organisms sufficiently alive to respond to one another.-See also:*Forms of activity and interpersonal relations*List of sociology topics*Social fact-References:...

 where external economic
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 events combine with crowd behavior
Crowd psychology
Crowd psychology is a branch of social psychology. Ordinary people can typically gain direct power by acting collectively. Historically, because large groups of people have been able to bring about dramatic and sudden social change in a manner that bypasses established due process, they have also...

 and psychology in a positive feedback
Positive feedback
Positive feedback is a process in which the effects of a small disturbance on a system include an increase in the magnitude of the perturbation. That is, A produces more of B which in turn produces more of A. In contrast, a system that responds to a perturbation in a way that reduces its effect is...

 loop where selling by some market participants drives more market participants to sell.
Discussions
Encyclopedia
A stock market crash is a sudden dramatic decline of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

 prices across a significant cross-section of a stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

, resulting in a significant loss of paper wealth
Paper wealth
Paper wealth means wealth as measured by monetary value, as reflected in the price of assets – how much money one's assets could be sold for. Paper wealth is contrasted with real wealth, which refers to one's actual physical assets....

. Crashes are driven by panic
Panic
Panic is a sudden sensation of fear which is so strong as to dominate or prevent reason and logical thinking, replacing it with overwhelming feelings of anxiety and frantic agitation consistent with an animalistic fight-or-flight reaction...

 as much as by underlying economic factors. They often follow speculative
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...

 stock market bubble
Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....

s.

Stock market crashes are social phenomena
Social phenomenon
Social phenomena include all behavior which influences or is influenced by organisms sufficiently alive to respond to one another.-See also:*Forms of activity and interpersonal relations*List of sociology topics*Social fact-References:...

 where external economic
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 events combine with crowd behavior
Crowd psychology
Crowd psychology is a branch of social psychology. Ordinary people can typically gain direct power by acting collectively. Historically, because large groups of people have been able to bring about dramatic and sudden social change in a manner that bypasses established due process, they have also...

 and psychology in a positive feedback
Positive feedback
Positive feedback is a process in which the effects of a small disturbance on a system include an increase in the magnitude of the perturbation. That is, A produces more of B which in turn produces more of A. In contrast, a system that responds to a perturbation in a way that reduces its effect is...

 loop where selling by some market participants drives more market participants to sell. Generally speaking, crashes usually occur under the following conditions: a prolonged period of rising stock prices and excessive economic optimism
Optimism
The Oxford English Dictionary defines optimism as having "hopefulness and confidence about the future or successful outcome of something; a tendency to take a favourable or hopeful view." The word is originally derived from the Latin optimum, meaning "best." Being optimistic, in the typical sense...

, a market where P/E ratio
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...

s exceed long-term averages, and extensive use of margin
Margin (economics)
In economics, a margin is a set of constraints conceptualised as a border. A marginal change is the change associated with a relaxation or tightening of constraints — either change of the constraints, or a change in response to this change of the constraints.- Extensive and intensive margins...

 debt and leverage by market participants.

There is no numerically specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....

 over a period of several days. Crashes are often distinguished from bear markets by panic selling
Panic selling
Panic selling is a wide-scale selling of an investment, in order to get out of an investment . The main problem is that investors react simply out of emotion and fear, without evaluating the fundamentals. Almost all market crashes are caused by panic selling. Most major stock exchanges use trading...

 and abrupt, dramatic price declines. Bear markets are periods of declining stock market prices that are measured in months or years. While crashes are often associated with bear markets, they do not necessarily go hand in hand. The crash of 1987
Black Monday (1987)
In finance, Black Monday refers to Monday October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin...

, for example, did not lead to a bear market. Likewise, the Japanese Nikkei
Nikkei 225
The , more commonly called the Nikkei, the Nikkei index, or the Nikkei Stock Average , is a stock market index for the Tokyo Stock Exchange . It has been calculated daily by the Nihon Keizai Shimbun newspaper since 1950. It is a price-weighted average , and the components are reviewed once a year...

 bear market of the 1990s occurred over several years without any notable crashes.

Wall Street Crash of 1929

The economy had been growing robustly for most of the so-called Roaring Twenties
Roaring Twenties
The Roaring Twenties is a phrase used to describe the 1920s, principally in North America, but also in London, Berlin and Paris for a period of sustained economic prosperity. The phrase was meant to emphasize the period's social, artistic, and cultural dynamism...

. It was a technological golden age as innovations such as radio, automobiles, aviation, telephone and the power grid
Electric power transmission
Electric-power transmission is the bulk transfer of electrical energy, from generating power plants to Electrical substations located near demand centers...

 were deployed and adopted. Companies that had pioneered these advances, like Radio Corporation of America (RCA) and General Motors
General Motors
General Motors Company , commonly known as GM, formerly incorporated as General Motors Corporation, is an American multinational automotive corporation headquartered in Detroit, Michigan and the world's second-largest automaker in 2010...

, saw their stocks soar. Financial corporations also did well as Wall Street
Wall Street
Wall Street refers to the financial district of New York City, named after and centered on the eight-block-long street running from Broadway to South Street on the East River in Lower Manhattan. Over time, the term has become a metonym for the financial markets of the United States as a whole, or...

 bankers floated mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...

 companies (then known as investment trust
Investment trust
An Investment trust is a form of collective investment found mostly in the United Kingdom. Investment trusts are closed-end funds and are constituted as public limited companies....

s) like the Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...

 Trading Corporation. Investors were infatuated with the returns available in the stock market especially with the use of leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...

 through margin debt.

On August 24, 1921, the Dow Jones Industrial Average
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...

 stood at a value of 63.9. By September 3, 1929, it had risen more than sixfold, touching 381.2. It would not regain this level for another twenty-five years. By the summer of 1929, it was clear that the economy was contracting and the stock market went through a series of unsettling price declines. These declines fed investor anxiety and events soon came to a head on October 24 (known as Black Thursday
Black Thursday
Black Thursday is a term used to refer to events which occurred on a Thursday. It has been used in the following cases:* February 6, 1851, Black Thursday, a day of devastating bushfires in Victoria, Australia...

) and October 29 (known as Black Tuesday).

On Black Tuesday, the Dow Jones Industrial Average fell 38 points to 260, a drop of 12.8%. The deluge of selling overwhelmed the ticker tape
Ticker tape
Ticker tape was the earliest digital electronic communications medium, transmitting stock price information over telegraph lines, in use between around 1870 through 1970...

 system that normally gave investors the current prices of their shares. Telephone line
Telephone line
A telephone line or telephone circuit is a single-user circuit on a telephone communication system...

s and telegraphs were clogged and were unable to cope. This information vacuum only led to more fear and panic. The technology of the New Era, much celebrated by investors previously, now served to deepen their suffering.

Black Tuesday was a day of chaos. Forced to liquidate their stocks because of margin call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...

s, overextended investors flooded the exchange with sell orders. The glamour stocks of the age saw their values plummet. Across the two days, the Dow Jones Industrial Average fell 23%.

By the end of the weekend of November 11, the index stood at 228, a cumulative drop of 40 percent from the September high. The markets rallied in succeeding months but it would be a false recovery that led unsuspecting investors into further losses. The Dow Jones Industrial Average would lose 89% of its value before finally bottoming out in July 1932. The crash was followed by the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

, the worst economic crisis of modern times.

Trading curbs

Trading curb
Trading curb
A trading curb, also known as a circuit breaker, is a point at which a stock market will stop trading for a period of time in response to substantial drops in value.-Circuit breakers:...

s, also known as "circuit breakers", are a trading halt in the cash market and the corresponding trading halt in the derivative markets triggered by the halt in the cash market, all of which are affected based on substantial movements in a broad market indicator.

United States

There are three thresholds each of which represents different level of decline in terms of points in Dow Jones industrial average.
  • In the event where threshold 1 is breached, the first halt is triggered. If that point is reached before 2 p.m., the market would shut down for an hour. If threshold 1 is breached between 2 p.m. and 2:30 p.m., the halt will last 30 minutes. No trading stops will take place if threshold 1 is breached after 2:30 p.m.
  • If threshold 2 is breached before 1 p.m., the market would close for two hours. If such a decline took place between 1 p.m. and 2 p.m., there would be a one-hour pause. The market would close for the day if stocks sank to that level after 2 p.m.
  • In the event where threshold 3 is breached, the market would close for the day, regardless of the time.


The thresholds are computed at the beginning of each quarter to establish a specific point value for the quarter.

For the second quarter of 2011, threshold 1 is 1200 points, threshold 2 is 2400 points, and threshold 3 is 3600 points.

The rules would halt trading on the major securities and futures exchanges in a coordinated cross-market halt if the circuit breaker is enacted.

France

In France
France
The French Republic , The French Republic , The French Republic , (commonly known as France , is a unitary semi-presidential republic in Western Europe with several overseas territories and islands located on other continents and in the Indian, Pacific, and Atlantic oceans. Metropolitan France...

, daily price limits are implemented in cash and derivative markets. Securities traded on the markets are divided into three categories according to the number and volume of daily transactions and price limits vary depending on the category to which the security belongs. For instance, for the more liquid category, when the price movement of a security exceeds 10% from the quoted price at the close of the previous market day, quotation is suspended for 15 minutes. After 15 minutes, transactions are resumed. If the price then goes up or down by more than 5%, transactions are again suspended for 15 minutes. The 5% threshold may apply once more before transactions are halted for the rest of the day. When transactions are suspended in the cash market on a given security, due to undue price movement, transactions on the option based on the underlying security are also suspended. Further, when more than 35% of the capitalization of the CAC­40 Index is unable to be quoted, the calculation of the CAC­40 Index is suspended and the index is replaced by a trend indicator. When less than 25% of the capitalization of the CAC­40 Index is able to be quoted, quotations on the derivative markets are suspended for half an hour or one hour when additional margin deposits are requested.

Mathematical theory and stock market crashes

The mathematical characterisation of stock market movements has been a subject of intense interest. The conventional assumption has been that stock markets behave according to a random Gaussian or "normal" distribution. Among others, mathematician Benoît Mandelbrot
Benoît Mandelbrot
Benoît B. Mandelbrot was a French American mathematician. Born in Poland, he moved to France with his family when he was a child...

 suggested as early as 1963 that the statistics prove this assumption incorrect. Mandelbrot observed that large movements in prices (i.e. crashes) are much more common than would be predicted in a normal distribution. Mandelbrot and others suggest that the nature of market moves is generally much better explained using non-linear analysis and concepts of chaos theory
Chaos theory
Chaos theory is a field of study in mathematics, with applications in several disciplines including physics, economics, biology, and philosophy. Chaos theory studies the behavior of dynamical systems that are highly sensitive to initial conditions, an effect which is popularly referred to as the...

. This has been expressed in non-mathematical terms by George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...

 in his discussions of what he calls reflexivity of markets and their non-linear movement. George Soros said in late October 1987, 'Mr. Robert Prechter
Robert Prechter
Robert R. Prechter, Jr. is an American author and stock market analyst, known for his financial forecasts using the Elliott wave principle. Prechter is an author and co-author of 14 books, and editor of 2 books , his book Conquer the Crash is a New York Times bestseller...

's reversal proved to be the crack that started the avalanche'.

Research at the Massachusetts Institute of Technology
Massachusetts Institute of Technology
The Massachusetts Institute of Technology is a private research university located in Cambridge, Massachusetts. MIT has five schools and one college, containing a total of 32 academic departments, with a strong emphasis on scientific and technological education and research.Founded in 1861 in...

 suggests that there is evidence the frequency of stock market crashes follows an inverse cubic power law
Power law
A power law is a special kind of mathematical relationship between two quantities. When the frequency of an event varies as a power of some attribute of that event , the frequency is said to follow a power law. For instance, the number of cities having a certain population size is found to vary...

. This and other studies such as Prof. Didier Sornette
Didier Sornette
Didier Sornette is Professor on the Chair of Entrepreneurial Risks at Swiss Federal Institute of Technology Zurich . He is also a professor of the Swiss Finance Institute, a professor associated with both the department of Physics and the department ofEarth Sciences at ETH Zurich, an Adjunct...

's work suggest that stock market crashes are a sign of self-organized criticality
Self-organized criticality
In physics, self-organized criticality is a property of dynamical systems which have a critical point as an attractor. Their macroscopic behaviour thus displays the spatial and/or temporal scale-invariance characteristic of the critical point of a phase transition, but without the need to tune...

 in financial markets. In 1963, Mandelbrot proposed that instead of following a strict random walk
Random walk
A random walk, sometimes denoted RW, is a mathematical formalisation of a trajectory that consists of taking successive random steps. For example, the path traced by a molecule as it travels in a liquid or a gas, the search path of a foraging animal, the price of a fluctuating stock and the...

, stock price variations executed a Lévy flight
Lévy flight
A Lévy flight is a random walk in which the step-lengths have a probability distribution that is heavy-tailed. When defined as a walk in a space of dimension greater than one, the steps made are in isotropic random directions...

. A Lévy flight is a random walk that is occasionally disrupted by large movements. In 1995, Rosario Mantegna and Gene Stanley analyzed a million records of the S&P 500 market index, calculating the returns over a five year period. Researchers continue to study this theory, particularly using computer simulation
Computer simulation
A computer simulation, a computer model, or a computational model is a computer program, or network of computers, that attempts to simulate an abstract model of a particular system...

 of crowd behaviour, and the applicability of models to reproduce crash-like phenomena.

Research at the New England Complex Systems Institute
New England Complex Systems Institute
The New England Complex Systems Institute is an American research institution dedicated to advancing the study of complex systems. It was founded in 1996 and is located in Cambridge, MA.- Overview :...

 has found warning signs of crashes using new statistical analysis tools of complexity theory
Complex systems
Complex systems present problems in mathematical modelling.The equations from which complex system models are developed generally derive from statistical physics, information theory and non-linear dynamics, and represent organized but unpredictable behaviors of systems of nature that are considered...

. This work suggests that the panics that lead to crashes come from increased mimicry in the market. A dramatic increase in market mimicry occurred during the whole year before each market crash of the past 25 years, including the recent financial crisis. When investors closely follow each other’s cues, it is easier for panic to take hold and affect the market. This work is a mathematical demonstration of a significant advance warning sign of impending market crashes.

The study Switching processes in financial markets published in the Proceedings of the National Academy of Sciences reveals a general empirical law quantifying market behavior near bubbles and crashes.

The Hindenburg Omen
Hindenburg omen
The Hindenburg Omen is a technical analysis pattern that is said to portend a stock market crash. It is named after the Hindenburg disaster of May 6, 1937, during which the German Zeppelin Hindenburg was destroyed.- History :...

, developed by physics professor Jim Miekka, is a controversial indicator that is believed by many to predict stock market crashes.

See also

  • List of stock market crashes
  • Behavioral finance
    Behavioral finance
    Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

  • Business cycle
    Business cycle
    The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

  • Dot-com bubble
    Dot-com bubble
    The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...

  • Economic bubble
    Economic bubble
    An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

  • Economic collapse
    Economic collapse
    There is no precise definition of an economic collapse. While some might consider a a severe, prolonged depression with high bankruptcy rates and high unemployment an economic collapse, others would additionally look for a breakdown in normal commerce, such as hyperinfalation, or even a sharp...

  • Economic history
    Economic history
    Economic history is the study of economies or economic phenomena in the past. Analysis in economic history is undertaken using a combination of historical methods, statistical methods and by applying economic theory to historical situations and institutions...

  • Financial market
    Financial market
    In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...

  • Financial crisis
    Financial crisis
    The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

  • Flight-to-liquidity
    Flight-to-Liquidity
    A flight-to-liquidity is a financial market phenomenon occurring when investors sell what they perceive to be less liquid or higher risk investments, and purchase more liquid investments instead, such as US Treasuries...

  • Market trend
    Market trend
    A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...

  • Modeling and analysis of financial markets
  • Stock market
    Stock market
    A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

  • Stock market boom
  • Stock market bubble
    Stock market bubble
    A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....


Examples

  • Financial crisis of 2007–2010
  • Great Depression
    Great Depression
    The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

  • Meltdown Monday
    Meltdown Monday
    Meltdown Monday is a term used by some financial news outlets to describe Mondays with large losses in financial markets. In the late 1980s and early 1990s, the term was used most often in reference to October 19, 1987, which later became known as Black Monday 1987...

  • Subprime mortgage crisis
    Subprime mortgage crisis
    The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

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