Financial History

Stock market crash of 1929

The stock market crash of 1929, also known as the “Great Crash,” is considered by many to be the most significant collapse in the history of the United States stock market.

The stock market began to decline in September and early October. But it was not until the final week of October that panic took over, and the collapse was underway.

Thursday, October 24, 1929, signaled the beginning of the crash. October 28 is famously called “Black Monday.” The Dow Jones experienced a record loss of 12.8%.

Tuesday, October 29, the Dow lost an additional 11.7%. The stock market lost 23% of its value in two days.

After a series of rallies and crashes, the Dow Jones steadily declined for almost three years, when the stock market finally bottomed in July of 1932.

The Great Crash of 1929 is blamed for the beginning of the Great Depression, which lasted through the 1930s until World War II began.

Background

During the 1920s, the United States experienced unprecedented expansion in the economy and the stock market. Because of the rapid growth, this decade is referred to as the “Roaring Twenties.” For many citizens, the era of increased wealth led to excess, speculation, and a sense of euphoria.

From 1920 through early 1929, the stock market more than quadrupled in value. Despite predictions that the nine-year bull run was coming to an end, the average American treated the stock market as a seemingly risk-free way to make quick, easy money. Fear-of-missing-out was rampant, and many were investing their life savings into the market with hopes of becoming rich, often overextending their financial means through the use of margin.

There are many reasons cited as the cause of the Great Crash. Realistically, the collapse was not created by any one specific event, but by multiple factors that coincided to burst the asset bubble that had been building throughout the decade.

As the country experienced great industrial prosperity, many Americans relocated from their rural homes to metropolitan cities. While the cities became prosperous, the exodus led to an overproduction crisis for the agricultural sector, and many farmers fell destitute as the decade progressed.

Despite the slow decline in agriculture, America was booming in the 1920s. Unemployment was low, the economy was strong, and the general population believed the prosperity would never end. The overconfidence led many to invest their money into an increasingly overvalued stock market.

Interest rates were kept low, credit was easy to come by, and banks generously loaned money. Many people used the borrowed money to purchase stocks on margin, meaning they only had to put down a fraction of the cost to hold positions.

As the decade roared on, signs of trouble began to emerge. Because of the easy credit, consumers were accumulating personal debt beyond their income. Key industry sectors began to show weakness as overproduction led to an oversupply of goods. Steel production, automobile sales, and construction were all in decline.

Exacerbating the situation was the Federal Reserve’s decision to abruptly raise interest rates from 5% to 6% in August of 1929. Many experts believe that this was a driving force for the sharp selloff that would come two months later.

In the early months of 1929, financial experts warned of potential trouble ahead. In March, the Federal Reserve cautioned investors that the market was overvalued. The stock market reacted with a brief selloff as many were quick to exit their positions.

However, just two days later, the National City Bank pledged $25 million in liquidity to prevent a crash. It worked; the Dow Jones resumed its steady climb upwards, gaining 20% between June and September. In September, many prominent economists claimed that the stock market bull run was about to come crashing down.

By September, the market began to show real signs of weakness. A famous quote from Roger Babson declared, “A crash is coming, and it may be terrific.”

Furthermore, the London Stock Exchange went through its own crash on September 20. Three weeks later, the Dow Jones hit an all-time high of 381 and investors scrambled to withdraw their money. It was clear the market was on shaky ground.

Despite Wall Street’s uneasiness in early October, prices were quick to rebound from intermittent selling, and many believed the worst was over.

However, on Thursday, October 24, the bottom fell out, and the Dow Jones declined 11% in early trading. Trading volume was very high as panic began to take hold, but many did not know what was happening in real-time in the days before computers and television. This led to delayed price quotes and confusion as the public was unaware of the actual price of securities.

The major Wall Street banks held an emergency meeting, and a mutual agreement was reached to try and salvage the massive losses. Large amounts of money were injected into the market as the big banks used their resources to buy major stocks. The Dow Jones temporarily recovered and gained back most of the day’s losses, but the worst was still to come.

The Crash

“Black Monday” opened, and the aggressive selling began again.

The weekend newspapers informed the public of the trouble from the previous week. Many were faced with margin calls, which required investors to exit their positions. The margin that had enabled so many to purchase stocks was now forcing them to sell, which accelerated the sharp decline.

The panic extended into “Black Tuesday,” and the stock market lost nearly a quarter of its value in two trading sessions. As sell orders continued to pile up, there were simply no buyers willing to take the other side of the trade.

More attempts were made to stop the selloff, and the government, including President Hoover, tried to ease the public’s concerns. A brief rally came mid-week, but the market continued to fall until it reached a short-term bottom on November 13.

For a while, it appeared stocks were rebounding. From mid-November through April 1930, the Dow Jones climbed 40%. Then, a long-term selloff began again.

The stock market steadily declined until July 1932, when the Dow Jones finally bottomed out after reaching its lowest level ever. The market fell from 381 points to 41, losing nearly 90% in under three years. While the “Great Crash” occurred over two days, the economic repercussions were felt for an entire decade.

Lasting Effects

In the days that followed the initial collapse, panicked investors tried to withdraw their money from banks but could not do so, as the banks had used their money to invest in the stock market. These bank runs contributed to many failures, which made a bad financial situation worse.

The misuse of public funds led to the creation of the Pecora Commission, which was established in 1932 by the United States Senate to investigate the causes of the collapse. As the country sunk into an economic depression, the investigation exposed the misdeeds of financial institutions, and an increasingly impoverished nation demanded change.

Pecora’s findings eventually brought about the Glass-Steagall Act. Among its many contributions, the Glass-Steagall Act led to the creation of the FDIC. It delineated a clear line between commercial banks and investment banks so that the savings of Americans could not be used for speculation by the large banks.

The Pecora Commission also contributed to the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934, which helped to establish the Securities and Exchange Commission (SEC).

The stock market crash of 1929 exposed the fragility of financial markets. The decade of excess and speculation led to the repercussions of irresponsible investing by banks and individuals.

In the aftermath, the stock market instituted preventative measures to shut down markets for brief periods to slow the rapid selling of stocks. But the damage had been done.

The decade following the “Great Crash” was among the worst in American history. The lack of banking regulations, unprecedented growth, and widespread speculation created a bubble that eventually burst, crippling the national economy until World War II.

Unemployment and poverty swept through America, wages collapsed, and deflation took hold. It would be nearly 25 years before the Dow Jones reached its pre-crash level of $381.

Black Monday - October 1987

“Black Monday” is the name given to October 19, 1987. On that date, stock markets around the world collapsed simultaneously as a wave of selling dropped markets to one of the worst single-day losses in financial history. The U.S. stock market fell more than 22%, the largest percentage drop in a day, as equity, options, and futures markets all crashed.

Numerous causes were to blame for the sudden and unexpected collapse, yet no singular event was pinpointed as the catalyst. Instead, a combination of economic factors and technological failures converged on global markets to swiftly bring an end to years of continuous growth in the economy.

The impact of the crash of 1987 was brief: by week's end the Dow had regained nearly half the value lost on Monday. However, it would be another two years before the stock market reached the levels it traded at before Black Monday.

Background

From 1982 through August 1987, the Dow Jones nearly quadrupled in value. The major stock markets around the world also experienced similar growth. The recessionary period of the early 1980s had given way to rapid expansion and consumer excess.

Many economic headwinds were slowly building though. The stock market had been in a five-year bull market with an above-average price/earnings ratio. Inflation was steadily rising, a strong U.S. dollar was negatively affecting exports, and the trade deficit was growing.

Despite five years of relentless upward movement in the Dow Jones, investors ignored the warning signs and continued to pour money into the stock market. This was bolstered by a new wave of computerized trading.

Program trading, specifically portfolio insurance, was a new phenomenon on Wall Street and gave many investors a false sense of comfort. This overconfidence is believed to be a significant reason for the crash of 1987. Portfolio insurance was designed to protect downside risk by mechanically hedging against short-term price fluctuations.

This false belief of autonomous safety encouraged more risk-taking. However, when prices began to decline, the computers stepped in and increased the rate at which assets were sold, thus accelerating the collapse.

The United States government and the governments from major countries worldwide also played an important role in the stock market crash of 1987.

The Plaza Accord of 1985 was an agreement between the Federal Reserve and the G-5 countries to devalue the American dollar to help offset the rising deficit. The plan worked; in 1987, the Plaza Accord was replaced by the Louvre Accord, which resulted in actions to counteract the previous monetary policy. The Plaza Accord’s positive effects were quickly replaced by the Louvre Accord’s negative effects, and the stock market was beginning to slow as the economy entered the third quarter.

The week before Black Monday, the government committee in charge of writing taxes announced a new tax bill. The new legislation would be detrimental to large corporations involved in mergers and acquisitions. The unexpected news, coupled with a surprisingly high trade deficit, was the first indication that a massive sell-off was coming.

The Crash

Like 1929, selling began the week before Black Monday and offered a warning of the chaos to come the following week. Aided by the new monetary policies and increasing unease regarding Middle Eastern relations, stocks began steadily selling off in the days leading up to October 19th.

With the fear that something significant was about to happen, many investors and firms initiated selling over the weekend. By the time markets opened Monday morning, there was a massive imbalance of sell orders waiting to be executed.

Volume was so large that many orders were left unfilled and did not trigger until much later in the day. Dozens of stocks on the Dow Jones and S&P didn’t begin trading until after the opening bell. Multiple halts were placed in individual securities as the wave of selling continued.

Panic quickly spread across the exchanges as an essential link between the derivatives markets, and the equity market broke down.

Typically, futures markets act as an indicator for the direction of the stock market. But because so many stocks were delayed and halted, equity prices lagged behind the futures market’s real-time pricing. Equities and their derivatives were in divergence from one another.

The opportunity to sell at levels higher than the market’s actual value encouraged many participants to take advantage of the mis-pricings and flood the system with sell orders. The human element of fear was accelerated by the computerized trading algorithms, and the sell-off intensified as the day went on.

Technological systems malfunctioned, and orders were left unfilled for hours, creating confusion and chaos on the exchange floor.

Many investors faced margin calls as over-leveraged brokerage firms scrambled to avoid insolvency. Individual traders and large institutions were forced to liquidate positions to cover the cost of their mounting losses. This created additional selling pressure as everyone rushed to exit positions at once to fulfill credit obligations.

By the time the trading session ended, the Dow Jones had lost 500 points, more than 22% of its value from the previous Friday’s close.

Lasting Effects

The Black Monday crash of 1987 did not affect the United States economy alone. Stock markets in nearly every developed country experienced a similar collapse that day.

The suddenness of the selloff and it’s widespread influence highlighted the downside of globalization. As nations across the world had become increasingly interconnected, fears of future instability--and its effect on the global economy--grew. Nearly 20 countries experienced a single-day loss of at least 20% in their respective markets.

Collectively, many countries reacted by loosening monetary policy in an attempt to provide quick relief in the form of liquidity. The Federal Reserve stepped in immediately to supply a capital injection into the markets.

By all accounts, the Fed’s decisive response was a success. Markets stabilized, confidence slowly returned, and banks were persuaded to continue to lend to consumers, which allowed the economy to avoid recession.

While the crash itself was short-lived, it was extreme, and exposed the underlying flaws in the computerization of financial markets. The emotional elements that underlie any great crash will always be the driving force, but with technological advancements, reactions happen on a much faster timeframe.

“Circuit breakers” were installed to help prevent abrupt market crashes, such as October 19, 1987. These precautionary tools require exchanges to halt trading for a period of time if stocks or indices decline by a certain amount, thereby allowing investors to collect themselves and assess the situation. 

History had again repeated itself, with many of the same causes from 1929 reemerging. Excess, speculation, and leveraged borrowing to fund risk were again the main catalysts preceding the crash. The advent of technology expedited the process and an increasingly globalized marketplace saw countries across the world endure a similar experience together.

With federal intervention, the effects were brief, and the Dow Jones actually finished positive for the year. But, Wall Street was again reminded that the unexpected could happen at any time.

Tech bubble - 1998-2000

The “dot-com” crash, also known as the tech bubble, was a period of market speculation and eventual disaster at the turn of the 21st century. As the internet became more accessible to consumers, countless companies formed to capitalize on the new frontier. 

Investors saw new opportunities, and an enthusiasm overtook financial markets. Technology stocks climbed to extreme valuations. Founders were wealthy, and investors were rewarded until early 2000, when the asset bubble burst. The Nasdaq, a tech-focused index, fell for two and a half years, ultimately bottoming 75% below its speculative high.

No meaningful regulation came from the dot-com crash, but the events in financial markets and the technology that produced them continue to impact the world.

Background

The late 1990s saw a strong stock market performance, rebounding after a sluggish first half of the decade. Federal Reserve Chairman Alan Greenspan raised interest rates throughout 1994-1995 to combat inflation, settling around 5.5%. Monetary policy was the sole option for economic influence, as fiscal support was used solely as a tool for deficit reduction. 

Previously, the internet had been a premium service not available to the average consumer. Netscape changed this in 1996 by introducing an intuitive, easily accessed web browser built for the consumer. This breakthrough, and others like it, began the meteoric rise of internet usage that continues today.

Existing companies and entrepreneurs saw the opportunity of e-commerce, and “dot-com” businesses flooded the market. Companies like Pets.com, Geocities, Amazon.com, and Boo.com became well-known names. Venture capitalists and private equity groups were willing to fund these new companies, providing capital long before signs of profitability.

Dot-com businesses prioritized excessive growth and increasing market share with little regard for profitability or fiscal responsibility. Without reliable cash flow, these companies required continual funding, eventually sending them to the public markets. Public market investors were just as willing to provide capital, with some initial public offerings gaining over 100% on their listing day. 

Valuation metrics rose far beyond any previous highs, with the Nasdaq eventually trading at 200x company earnings. These factors formed what Alan Greenspan famously called “irrational exuberance,” culminating on a fateful day in early 2000.

The Crash

The Nasdaq reached a peak of $5048.62 on Friday, March 10, 2000. The index opened down more than 3% on Monday, beginning one of the most intense sell-offs in market history. The index continued a nearly unabated fall for two and a half years, finally bottoming on October 10, 2002, down 75% from its high.

By the Great Financial Crisis, the Nasdaq was still 64% below its all-time high.

In an attempt to relieve selling pressure, Federal Reserve Chair Alan Greenspan reversed his earlier course and aggressively cut interest rates, bringing the Federal Funds rate to ~1%. Greenspan hoped that easing monetary policy could save the struggling stock market. However, loose monetary policy was not enough to halt the trend.

The dot-com crash extended beyond the tech sector, with the S&P 500 falling 46% from high to low. The index would not reach its previous high for nearly five years, closing above the tech-bubble high on March 31, 2007.

There is no clear answer for what caused the bubble to burst. Potential catalysts are the Japanese recession, or simply that investors did not have sufficient capital to maintain the rich valuations.

After the fact, many blamed private equity investors for their lack of restraint in allocating capital. These investors funded the flashy lifestyles of founders that characterized the early 2000s.

Others blame Alan Greenspan’s interest rate cut in the late 1990s, a policy designed to limit the impact of Y2K, a broad computer bug that impacted how computers would interpret the year “2000.” Cutting rates stimulated the economy and stock market at a time when it was already highly valued. As with all bubbles, there is no single person or event to blame.

Lasting Effects

The indices eventually recovered their extreme losses, but the tech bubble impacted the world beyond the early 2000s. 

Alan Greenspan’s aggressive interest rate cuts began a season of low rates that persists 20 years later. 

Hidden behind speculation and market exuberance were meaningful businesses with future potential. Companies like Amazon.com and Ebay.com survived the crash and thrived in the following years. These technology companies still fetch high market valuations, but nowhere near the early 2000s levels. 

Although the majority of dot-com companies failed, the event normalized non-traditional initial public offerings. Low-profitability, high-growth companies now regularly raise capital in public markets. Investors are willing and excited to invest money in unproven, high-reward businesses. This fascination started with the tech bubble.

The dot-com crash was an extreme psychological response to one of the most impactful inventions in human history. The internet produced the excitement and eventual calamity that characterize the tech bubble. The lasting effects are minor footnotes relative to the overwhelming impact of the internet on financial markets and the world.

Great Financial Crisis - 2007-2008

The financial crisis of 2007-2008 is also known as the Global Financial Crisis. Unlike the past economic crises, the Global Financial Crisis did not stem from an isolated market event. The collapse occurred steadily, as the buildup from an unraveling economic system progressively gave way to months of falling stock prices and economic recession.

It is difficult to pinpoint a singular event that burst the bubble, and blame has been placed everywhere. A frequent scapegoat is large institutional banks and their willingness to take excessive risk on suspect investments. Many accuse the U.S. government of enabling Wall Street to dig themselves into a massive, debt-filled hole and are equally upset with the government’s monetary response during the crisis to bail them out.

It is also fair to say that the average American citizens helped fuel this crash as much as any other crash in the 20th century. The United States was living on debt. Banks were lending money and the population used credit to purchase assets that exceeded their financial means.

All bets were on the real estate market, which many incorrectly believed could not go down. But when it did, the entire global economy felt the impact for months and years.

Background

Since 2003, the Dow Jones climbed steadily to new all-time highs year after year. Despite a strong fiscal year in 2006, trouble emerged in the housing market.

For years, home prices had increased exponentially. Everyone believed that real estate, and more specifically, mortgages, was a safe way to make consistent, above-average returns. But in 2006, home prices peaked. At the same time, mortgage defaults began to rise, and the real estate market showed signs of weakness.

The American economy had built itself around the belief that real estate was a safe haven. This premise proved false, with a domino effect of consequences in the U.S. and beyond.

The full effects of the financial crisis weren’t felt until late 2008, but the trouble began years before.

Housing prices were increasing at an above-average rate. To afford the pricier homes, prospective homeowners needed to borrow more money. Though interest rates had climbed since 2000, they were still low by historical measures, which encouraged borrowers to take larger loans.

To keep up with home buyers’ demand, banks and lending agencies began to loan money to riskier parties, with lax credit guidelines and little or no income verification. “Teaser loans,” with adjustable-rate mortgages and low monthly payments for the initial years of a mortgage, aided prospective buyers to stretch into pricier homes.

Over time, as adjustable rate mortgages made monthly payments progressively more expensive, individuals were unable to pay their mortgages, and delinquencies started to rise. The stock market took notice.

In February 2007, the market had its worst day in nearly four years when the Dow Jones fell more than 3%.

In the months that followed, it became increasingly clear that the mortgage industry was vulnerable. Delinquencies continued to rise, and defaults were common. To make matters worse, many large institutional banks had invested billions of dollars into the market in the form of mortgage-backed securities.

Mortgage-backed securities consisted of individual mortgages bundled together into large pools, and sold in shares to investors and other banks. More and more mortgages were being lent to below-average candidates in the form of subprime loans and mortgage-backed securities were becoming riskier. Debtors were unable to pay their mortgages, the underlying subprime loans defaulted, and the value of the securities plummeted, leaving many large banks with huge losses on their books.

Banks had become irresponsible with their risk management and over-leveraged their exposure to what was becoming a volatile asset.

The financial institutions took it one step further with credit default swaps. The banks sold credit default swaps on the flawed assumption that the underlying mortgage-backed securities were safe investments. Credit default swaps resemble insurance contracts, and when sold, the seller receives a premium in exchange for bearing the risk if the underlying loan defaults.

Mortgage defaults continued to increase, and the banks who sold credit default swaps were forced to cover the cost of the unpaid loans.

The Crash

There was no specific date for the beginning of the Great Financial Crisis.

The Federal Reserve lowered interest rates in September 2007 for the first time in four years, indicating that they were worried about potential problems ahead. January had the worst open to a year since 2000.

In March, Bear Stearns, a prominent fixture on Wall Street for decades, nearly filed for bankruptcy. Instead, JP Morgan acquired the bank, with additional funding provided by the Federal Reserve.

It was becoming apparent that the excessive risk-taking by the large investment banks was catching up with them. Panic took over Wall Street, and the government scrambled to find solutions to keep the financial system solvent.

Billions of investment dollars had been allocated to mortgage-backed securities, collateralized debt obligations, and credit default swaps. Rating agencies had given out misleading ratings for banks and their risky loans for years, which helped fuel the instability. The housing bubble collapsed, and supply overtook demand as houses became unaffordable.

In March of 2008, the Federal Reserve cut interest rates for the sixth time in six months. By June, the stock market was down 20% from its recent all-time highs in October.

In September, the second investment bank dissolved when Lehman Brothers filed for bankruptcy. Bank of America acquired Merrill Lynch, and the world knew that the big banks in the United States were in unprecedented times.

The Federal Reserve intervened in an attempt to help limit the damage. AIG, an insurance company that effectively insured all the banks against loan defaults through credit default swaps, was on the verge of bankruptcy. The Fed believed this would be the catalyst for a global economic crisis and provided $85 billion in emergency relief to fund AIG’s debt.

The public was outraged. Many Americans were slipping into poverty as unemployment rose to its highest level since the Great Depression, and were furious that Wall Street was receiving bailouts from the government. The masses hurried to remove their money from at-risk banks; the credit market was falling apart.

The Federal Reserve held an emergency meeting to address the issue and attempted to pass legislation that would provide financial relief to the struggling investment firms, lending agencies, and insurance companies. The bill was denied in Congress, and the stock market had its worst day since the crash of 1987.

In early October 2008, the United States stock market lost nearly 20% in one week. Around the world, specifically in Europe, countries were experiencing the same crisis.

Congress stepped in to control the panic and introduced numerous funding programs to secure the financial markets and institutions. Notably, an $800 billion stimulus package was announced to aid in economic recovery for the general public.

The Troubled Asset Relief Program (TARP) was announced, enabling the Federal Reserve to purchase toxic assets from institutional banks, as well as the Term Asset-Backed Securities Loan Facility (TALF) to increase consumer credit lending.

The Federal Reserve lowered the Fed Funds interest rate to zero. It would be seven years before rates increased again.

By March of 2009, the Dow Jones had lost over half its value. It took a year and a half from the highs of October 2007, but the stock market had finally reached the bottom. It would take three and a half years for the market to reach its pre-crash levels, and the economy struggled.

Unemployment remained above 8% until 2013, and many questioned why the “too big to fail” corporations were given relief as the American population continued to struggle.

Lasting Effects

The government intervention initiated by the Federal Reserve helped to stabilize the debt market and prevented financial institutions from an otherwise unavoidable collapse. In all, almost $1.5 trillion was given to banks, insurance companies, homeowners, and the auto industry.

But the lasting effects of their actions are still debated.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed. The Act was responsible for restructuring the laws surrounding financial regulation in the form of more transparency and less risk-taking.

Regulations were put in place to protect borrowers from predatory lending practices by credit providers. However, it is argued by many experts that little has changed, despite the regulations put in place by the U.S. government.

Economists say that the money injected into the financial system merely bailed out banks in the short term, and nothing was learned from the events of 2007-2008. As a result, many of the big banks now have more purchasing power, thanks to mergers and acquisitions as ten banks control nearly 80% of the money supply in the United States.

Flash Crash - May 2010

On May 6, 2010, the United States stock market experienced a dramatic loss of value in a very short period of time. The “Flash Crash,” as it came to be known, caused the major indices to decline 9% spontaneously.

Over one trillion dollars of market value was lost in a matter of minutes. However, markets bounced back just as quickly. The majority of those losses were eliminated a half-hour later as prices returned to pre-crash levels.

Unlike prior stock market collapses, the Flash Crash did not lead to months or years of economic recovery. Instead, it proved to be an isolated event that exposed the dangers of high-frequency trading and the unintended consequences of what can happen when electronic systems fail.

Background

By 2010, almost all stock trading was electronic. The computerization of financial markets resulted in what seemed to be the most important asset in modern investing: speed.

The stock market is now traded through computers. Gone were the days of large groups of traders yelling over one another to execute trades. The archaic open outcry system had been replaced by computer systems and algorithms that instantly entered and exited the market based on programmed inputs.

Success was now measured in nanoseconds. As a result, many traders and institutions embraced the change and adopted technological trading into their strategies. Volume increased dramatically as large blocks of orders were executed instantaneously.

The new wave of trading had proved to be a welcome addition to the market until May 6, 2010.

The Crash

The morning of May 6, 2010, was volatile but showed no signs of the impending collapse. The major indices were down roughly 3% in early market action, but the volatility was nothing compared to the unexpected drop that began at 2:42 pm.

Within five minutes, the Dow Jones lost an additional 6%.

Orders flooded the market, and liquidity disappeared as computer algorithms triggered a cascade of selling. However, the panic was short-lived, and within twenty minutes, the Dow Jones had regained the 600 points lost during the crash.

The rapid decline in stock prices was unexpected. No economic or political news broke to instigate the sudden collapse. The cause was later blamed on high-frequency trading (HFT).

High-frequency trading relies on computer software to execute trades based on complicated algorithms. The algorithms allow a substantial quantity of trades to be entered in fractions of a second. The software is designed to react to changing market conditions. As prices fluctuate, the computers enter and exit trades electronically.

In the case of the Flash Crash, when the algorithms detected selling pressure, they initiated sell orders to protect positions from incurring unnecessary losses.

Large institutions had come to rely heavily on high-frequency trading models as a way to manage risk autonomously. Computerized trading added liquidity to financial markets because they can accomplish a much larger quantity of trades than humans in a fraction of the time. The liquidity was temporary, however, and orders appeared and disappeared instantly as the algorithms quickly reacted to changes in price and volume.

Eventually, the misappropriation of these powerful tools led to the Flash Crash.

Initially, there were several assumptions for the catalyst of the unforeseen events on May 6, 2010.

In September of the same year, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) filed a report that blamed a mutual fund for overwhelming the market with sell orders for S&P futures. An algorithm had been created to systematically sell large blocks of contracts every minute for a specified period of time.

However, when the orders began to fill, the algorithm misinterpreted the available volume in the market, and liquidity became scarce as buyers could not keep up with the automation, and other high-frequency trading software reacted to the selling. This spurred a collective barrage of sell orders as the computers scrambled to sell shares. Prices oscillated violently as bid and ask quotes could not keep up with the accelerated trading.

The initial selling gave way to more selling as the algorithms mechanically sold positions to hedge against falling prices. Eventually, the same computer software that began the collapse helped save it; the machines shut themselves down, and the market paused briefly.

The break allowed the computer trading systems, as well as the panicked trader-operators, to reassess the situation and reverse the selloff. The algorithms realized that prices were not at true market value and began buying back contracts.

Within twenty minutes, the market was back to normal as if nothing had ever happened.

Lasting Effects

The release of the findings from the SEC/CFTC report was met with skepticism. Many argued that the financial system could not be so fragile as to allow one large order to collapse the market.

Years later, in 2015, Navinder Singh Sarao, a resident of England, was arrested by the United States government for his role in the Flash Crash. Sarao was accused of “spoofing,”a strategy in which he would enter and delete large orders quickly. This would trick market participants into believing there was more liquidity available. The algorithms misread these fake orders, and the lack of volume eventually led to the selloff. 

As a result of the Flash Crash, Wall Street introduced additional “circuit breakers” to automatically halt trading for five minutes if a stock or index fell more than 10%. It is believed that the momentary stoppage on May 6 helped mitigate a potentially worse situation, and circuit breakers could help save the market in the future if another flash crash occurred. 

The Dow Jones experienced the second-largest intraday drop in price during the Flash Crash, only to recoup most of the losses shortly thereafter. In all, the crash lasted a little more than 30 minutes but identified a flaw in the new wave of technologically advanced computerized trading.

Pandemic Crash - 2020

Beginning February 24, 2020, the United States and global stock markets entered a sudden and dramatic decline brought on by the unexpected arrival of COVID-19. Markets in the U.S. and worldwide reacted to a future of uncertainty as the virus officially became a pandemic.

The collapse occurred over many days and weeks, and the market experienced extreme volatility not seen since the Financial Crisis of 2008. As investors attempted to adjust earnings estimates and economic projections to the new economic reality, markets gyrated violently up and down until finally reaching a bottom on March 25.

The stock market fell by more than 30% in just one month. The sudden drop marked the steepest decline in American history in such a short period. Within a few short weeks, stock indexes went from all-time highs to a bear market, while concerns of an international recession quickly grew.

Unlike the crashes of 1929 and 1987, when single-day collapses overwhelmed the market, the pandemic crash occurred as a reaction to unforeseen events that began in Asia and quickly made its way through Europe and America, affecting economies as the pandemic swept across the globe. By the end of March, Asia, Europe, and the United States had all instituted strict lockdowns and closed their borders.

In an attempt to prevent the spread of the virus, businesses shut down worldwide, forcing millions into unexpected unemployment. It was the largest increase in unemployment in history, matching levels from the Great Financial Crisis. Many corporations were forced into bankruptcy as they simply did not have enough cash reserves to cover months of zero revenue.

Background

In early 2020, the United States’ stock market had been on a nearly unabated bull run for years, having recovered from the Great Financial Crisis. During the previous decade, the Dow Jones almost tripled. New all-time highs were being made constantly with little or no pullback.

Interest rates were low relative to the historical average, and unemployment was near all-time lows.

The week of January 27, the major indices experienced a slight selloff as news began to emerge involving a potentially deadly virus in China. It was only the third down week in over four months. The market quickly recovered and was at all-time highs in the middle and late days of February.

While the stock market was seemingly healthy and corporate earnings were strong, there had been warnings of a possible correction in the future.

In 2019, the treasury yield curve inverted, often a harbinger of future market contraction and economic recession. Furthermore, corporate debt had risen considerably since the collapse of 2009, increasing by over 50% in the world’s largest economies.

The Crash

Monday, February 24, the markets gapped down considerably from Friday’s close, opening more than 900 points lower for a 3% loss over the weekend. Asian and European markets had been declining overnight as documented cases of COVID-19 spread rapidly throughout the regions.

By Friday, stock markets realized their worst week since the 2008 financial crisis. The major Wall Street indices dropped more than 10% in one week. Oil prices and Treasury yields plummeted as fears of an extended economic downturn increased.

The week produced the fastest drop from all-time highs to official correction territory in history.

The following week, indices rebounded strongly, only to finish flat by Friday afternoon. Markets were encouraged by the Bank of Japan’s decision to purchase government bonds to provide liquidity and help stabilize falling asset prices. This would foreshadow actions later taken by the Federal Reserve in the United States.

The following two weeks, the stock market experienced historically high volatility, with wild daily swings eventually giving way to a nearly 7,000 point decline in the Dow Jones. Monday, March 9, again became known as Black Monday, and the Dow Jones lost 1,800 points in one session.

The market was reacting to an ongoing disagreement between Saudi Arabia and Russia involving oil production and pricing. As countries continued to impose travel restrictions, the future oil demand declined significantly. To combat the falling prices from lack of demand, the world’s leading oil producers attempted to compromise and collectively ease production. However, Saudi Arabia and Russia could not reach an agreement and stubbornly decided to increase oil production, causing oil prices to collapse as supply far exceeded demand.

Stock markets worldwide reacted negatively, with the major U.S. markets all triggering multiple circuit breakers throughout the week, both in overnight futures trading and during regular market hours. Huge down days were followed by equally large up days, only to give back all the gains in the following session in wild back-and-forth trading.

Markets continued their freefall into the last week of the quarter. On March 15, the Federal Reserve held an emergency meeting and reduced interest rates to 0%. The Fed indicated they would begin the process of quantitative easing, allocating $700 billion to purchase assets from struggling institutions.

On March 23, the selling exhausted itself, and the stock market finally reached its lows.

The United States government also announced a stimulus package to help American workers who had been affected by the fallout from the coronavirus. Federal aid news helped stabilize markets, which began a steady climb out of the recessionary bear market.

Three months after the initial crash, the major U.S. indices had regained almost all of the losses and were trading just below the highs of February. Low interest rates and federal stimulus helped fuel the quick rebound. By September, the major market indices had reached new all-time highs.

The pandemic crash was a result of an unpredictable black swan event. Hopes of a vaccine and an eventual return to normalcy fueled optimism.  The Federal Reserve vowed to do everything in its power to keep the economy stable.

Entering 2022, markets had experienced an almost unabated climb since the March 2020 lows, as interest rates remained near zero and central banks provided liquidity to global financial markets. Markets were at an all-time high across the major indices.