The stock market has crashed several times throughout history, including the infamous Crash of 1929, Black Monday in 1987, and the financial crisis of 2008. 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 six different stock market crash catalysts that could contribute to the next plunge in the market…
1. Speculation
Many market crashes can be blamed on rampant speculation. The Crash of 1929was 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 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%, 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%. It would sting, but I’d still have $2,500. If I had borrowed an additional $5,000, a 50% 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 real estate investment trusts (REITs). 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 a 10-year Treasury note yields 3% and a certain REIT yields 5%, it may seem worth the extra risk to income-seeking investors to choose the REIT.
On the other hand, if the 10-year Treasury’s yield spikes to 4%, the REIT’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. So, if the 30-year mortgage rate were to spike to, say, 6%, it could dramatically slow down the housing market and cause homebuilder stocks to take a hit.
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% during the first trading session following the Sept. 11, 2001, terror attacks, as the uncertainty surrounding the attacks and the next moves spooked investors…
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