Last editedJune 20213 min read
The Australian stock market is currently riding high once more after 2020’s volatility, but how long will this last? Here’s what to know about stock market crashes, so that you can recognise the warning signs of an impending downturn.
What causes a stock market crash?
Most market crashes are caused by the same group of causes. Investors feel confident and optimistic, which pushes stock prices increasingly upward. When these prices exceed realistic value or an outside event causes confidence to plummet, a mass sell-off ensues and the market crashes. It’s also natural for the market to cycle between bear and bull stages, moving up and down along with the economy.
One useful metric is the cyclically adjusted price-to-earnings ratio (CAPE). This assesses a stock’s current value by comparing its current price to its earnings per share. Stocks with higher ratios are often overpriced, while lower ratios indicate better value. The figures are adjusted for inflation and averaged out over a 10-year period. Investors can also apply the CAPE ratio to the full market. A high ratio indicates that stocks are overvalued, which could mean an impending correction or crash.
Understanding the stock market crash 1929
When we think about a stock market fall, most of us immediately imagine the stock market crash of 1929 and the resulting Great Depression. As one of the most prolonged, serious stock market drops in history, it’s important for investors to understand what happened.
By 1929, the stock market was at the end of a 10-year bull market, with low interest rates to make borrowing cheap. Investors were overly exuberant, driving prices to unsustainable highs that couldn’t continue any longer. The market crashed as investors whipped one another into a mass-selling panic on Black Monday and Black Tuesday, when the Dow fell 13% and 12% for two days in a row. This caused a run on the banks, eventually leading to the long-lasting bear market of the Great Depression.
Understanding the Australian stock market crash in 2020
On March 16, 2020, Australia’s stock market experienced its worst trading day since 1987. Sparked by the emerging Covid-19 pandemic, investors all sold shares at the same time which caused the ASX 200 to drop a hefty 9.7 percent in one day. This was a good 30 percent drop from its recent record highs of 7.197 points on February 20.
The pandemic has caused intense market fluctuations since the start of 2020, first as global markets tanked due to the uncertainty surrounding the situation. Investors panicked about increases in unemployment, disruptions to the supply chain, and a drop in global production all sparked by the pandemic.
Yet lured by this drop in prices, other investors picked up low-priced bargain stocks which drove the market upward again until March of 2020. This caused both an Australian stock market crash and falls in numerous other markets worldwide. For example, Wall Street’s Dow Jones industrial index fell 10 percent in just a few hours, its worst trading day in 33 years.
Australia officially entered bear market territory with such a steep drop in trading. Oil prices took a hit too, caused by the significant reduction in both domestic and international travel. Yet this bear market only lasted 11 weeks. After this stock market fall, the market has quickly rebounded.
The sudden turnaround was partially due to amateur investors taking advantage of low-priced stocks, as well as government stimulus packages to get the country back on its feet. Central banks slashed interest rates to zero, and Australia’s Reserve Bank purchased $200 billion in government bonds. As a result of all these initiatives, in 2021 the Australian market is back to high trading levels once more. The Dow Jones has also rebounded out of its pandemic-driven crash, growing to its highest-ever levels thanks to over $5 trillion in stimulus money.
When will the stock market crash again?
So, looking at the stock market crashes of 1929 and 2020, what can we expect moving forward? Will the Australian stock market crash again? We’d need a crystal ball to know for sure, but there are a few indicators to be aware of. The market is growing but volatile, which means any investor should weigh options carefully. One factor to think about is the CAPE ratio mentioned above.
It’s also important to remember that no market experiences unlimited growth. At some point, markets are due for a correction and prices will fall. Another issue to keep in mind is that the pandemic still hasn’t ended. While the vaccine rollout has made investors optimistic, virus mutations could be a game-changer. Markets are cyclical, but by choosing a variety of assets and diversifying your portfolio you can ride out any future dips.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.