The phrase stock market crash brings to mind images of speeding ticker tape machines and panic on the trading floor. The common perception is that stock market crashes are random and unpredictable phenomenon. There is, however, a pattern to the markets larger fluctuations. The market crash is a familiar term but an unfamiliar concept.
To understand what happens in the market when a crash occurs, we first need to look to the period that precedes a crash. The cycle begins at a time when the stock market is weak and people are generally pessimistic about the financial future of themselves and country. The bear market has caused most people to sell many stocks in order to save some of their investment. This is the point where the smart investors can pick up undervalued stock at bargain prices. These smart investors know that the market will be turning in the near future and they can resell these stocks for a much higher price. This accumulation of undervalued stock causes the market to start to rise. The rising stocks will attract the attention of mutual funds, and as the mutual funds invest in the stock, billions of dollars are reintroduced to the market place. Mutual fund investments cause the market to gain even more as do investments by institutional investors. At this point, the market has begun to stabilize and stocks are no longer at bargain prices. Stock prices most likely reflect the intrinsic value of the stocks. Those who invested early have large profits.
The average investor though may still be skeptical about the stock market, given the recent bear market. As the stock prices continue to stabilize and more institutional investors get re- involved in the stock market, the individual investors begin to notice. The individual investors began buying stocks the market is flooded with capital since the individual investors make up the cast majority of total investors in the market.
This bull market exists as long as the market is on the rise and all stock involved are all gaining in value. Bull markets make everyone happy. Investors and companies alike are making money and enjoying it. There is a kind of euphoria in the country, and a feeling that things will only continue to go up from here.
At the peak of a bull market, many companies go public or make stock available for purchase to the public. An IPO is the term used when a company goes public. The reason IPOs show up when the market is in a bull period is because companies want to benefit from investor confidence. When individual investors are more optimistic, the company can gain the highest possible stock price. Individual investors often buy into IPOs with dollar signs in their eyes and anticipating instant riches from getting in on the ground floor of a companys stock history. Investing in IPOs is traditionally the method by that most small investors make their money. The bull market is further fueled and stocks begin doubling and tripling in value.
At this point, those smart investors who purchased the undervalued stock at the beginning of the cycle are sitting in a prime position. At the perceived top of the bull market these investors can sell their now overvalued stocks before the prices start to drop. In the height of a bull market, there are often incidents of widespread greed. Corporate scandals arise, retail investors start to use margin investing to gain more stocks, and irrational purchases are made. The market is perceived to have no end to its growth so people start doing whatever they can to gain more stock with the false expectation that they will be able to sell for profit later.
Once mutual funds and individual investors have fully invested their capital, the market becomes overbought. At this point the market can only go down. The speed of the downward trend is determined by the amount of negative news. As there are negative reports about stocks losing value, this causes more investors to sell and the cycle expands exponentially. The market always falls quicker than it has risen. If everyone tries to exit at the same time, there are no buyers for the stocks. If there is enough of a lack of buyers, the market can crash entirely. The capitulation of the market occurs when a massive amount of individual investors leave and the market bottoms out.