5 Reasons Stock Markets Crash

A stock market crash brings in mixed emotions. Some people get scared and panic due to the seemingly rapid decrease of paper wealth, while others get excited in anticipation of buying at the bottom. A stock market crash happens when a significant portion of the stock market drastically declines in most if not in all sectors. Though crashes are considered part of the stock market and some even think of it as healthy, the majority of the traders and investors dread it because of the losses that it brings. But what really causes a seemingly robust stock market to go down? Here are five reasons why.

1. Prolonged period of stock prices rising. Stock prices rise significantly due to heavy optimism in the market. If values of stocks continue to go up, sooner or later, these stocks will come to a point where they become too overpriced. The market has its way of bringing back its prices to reasonable ones or even bring some stocks to lesser than their real value in order to create more buying opportunities and better rooms for growth.

2. P/E ratios exceed long term averages. P/E stands for price-to-earnings ratio and it is one indicator of whether a particular stock is overpriced or undervalued. What traders and investors are looking for are stocks that are undervalued because sooner or later, they will rise and hit their right value or price. On the contrary, an overpriced stock will sooner or later go down to its real value. Overvalued stocks are to be avoided thus if traders and investors realize that their stocks in hand are priced high, they will scramble to take their profits and secure their positions by staying on the sidelines or by picking stocks that are undervalued. If too much selling occurs on the market, a crash will result.

3. Panic. This could be the biggest reason why stock markets crash. Panic is the result of market pessimism resulting to people racing their way out. It’s just like a building on fire where people run towards the emergency exit without giving any regard to anybody or anything around them. Most of the time, panic is illogical. Panic is emotionally driven thus further magnifies stock market crashes. Crashes aren’t as bad as they really seem but because of panic, values get too low with most people getting fearful in positioning themselves. 60 percent of stock market sell downs are being caused by panic. But who wouldn’t? If things seem to go the other way than expect, the most reasonable thing to do is get out.

4. Slow economy. Fundamentals precede everything, thus a slow moving economy normally leads to a downward moving economy. A slow economy is caused by a lot of factors such as poor leadership, political unrest, inflation rates, poor GDPs and GNPs, and even natural calamities. Everything discounts the market thus if things are generally bad, it is being reflected in the stock market. So why does these things affect the stock market? Simply because they are the business conditions that surround the market. If such conditions are bad, the default anticipation is that the business is going to be bad as well.

5. Too much leverage. Too much leverage causes losses. Borrowing too much money leads to saturation of the gains which either minimizes it significantly or leads to losses. On a healthy market, assets outdo liabilities. For example, a company that has a 10:1 leverage ratio has its assets 10 times more than its liabilities. Before a stock market crash, such ratio decreases, balances out to 1:1, and later on the liabilities outnumber the assets. Why does a stock market crash when liabilities outnumber the assets? Because people don’t want to invest in a losing company or market.

A particular stock market’s performance depends on its sector’s environment. Such environment includes everything within a certain economy. If most factors indicate optimism, a particular market will go up but if factors will indicate more pessimism, it will go down and a crash is a possibility.