Why are Financial Markets Crashing? Here’s how Crisis look like

Why does a market crash happen? What are the dynamics that underlie a very sharp drop in prices?

The causes of market crashes are many and in this article we will see the most important ones, those that are common to all the crashes we have seen in the history of the financial markets.

Why does a market collapse?

From the tulip bubble to the subprime crisis, the markets have always presented the same dynamics with regard to strong market declines and in this article we will see exactly what the causes are, both technically and fundamentally, which trigger the sharp declines that create what is called a "panic sell", i.e. sales triggered by fear.

The climate of fear and uncertainty are the masters in these contexts, but they are only the tip of the iceberg which usually takes a long time to come out into the open. Let’s see together the fundamental and technical causes of a market crash.

1) The macroeconomic causes

Let’s start with the main causes that refer to the macroeconomy, ie those factors that are fundamental to the performance of an economy. Among the most important macroeconomic data that are constantly monitored by professional operators we find the interest rates, the inflation rate and the unemployment rate.

Interest rates
They represent the cost of money, i.e. how expensive credit and debt a market player is.

Inflation
The inflation rate refers to us the rate of growth of prices within an economy, a fundamental parameter for central banks in establishing the state of health of a certain economic area.

Unemployment rate
The unemployment rate generally returns the state of health of an economy from the employment point of view, showing how many people are not working and consequently how many people are outside the consumption chain, which is fundamental for the normal rhythm of growth of the economy.

The most important factor among these is that of the interest rate, which directly affects inflation and unemployment. The interest rate is decided by the central banks of a given economic area and therefore an increase in it, ie the increase in the cost of credit, would at least in theory lead to a decrease in the inflation rate.

Central bank uses the inflation rate to decide if and how to move interest rates. The central banks of countries in important economic areas, such as the USA, EU, UK and Japan, have an inflation rate target of 2%, above which they will be inclined to raise rates and below which they are ready to lower rates.

It follows that strong imbalances on the inflation side lead the central bank of an economic area to intervene drastically to resolve the situation, creating situations of uncertainty within the economic system.

The unemployment rate has the function of "indicating" about a possible increase or decrease in inflation. Inflation normally rises due to consumption and consequently an increase in the unemployment rate corresponds to a decrease in consumption and a possible consequent decrease in the inflation rate. Again, if the unemployment rate rises and inflation does not fall, we have an obvious problem. When we find ourselves faced with imbalances of this kind on the macroeconomic front we can expect a market collapse, with the only unknown factor being the timing, i.e. we don’t know when it will happen, but its probability of realization is very high given that historically it is precisely in the presence of imbalance dynamics of these factors that we have seen more or less important market collapses.

2) The fundamental causes

The fundamental causes mainly refer to the difference between the actual value of a financial instrument and its market price.

Let’s take a simple example using as a reference the tulip bubble burst in Amsterdam in 1637. Many market operators bought tulips simply because the price rose, in practice they were only bought from a speculative point of view. The price was so high that with a few tulip bulbs you could buy a property in the Dutch capital, a real madness. When the market realized that the price to pay for a tulip bulb was excessive, the market began to sell resulting in the price crash and many losses for those who had the tulips. This example tells of the very first speculative bubble.

The cause was precisely of a fundamental nature: it is objectively absurd that a tulip bulb costs as much as a property.

As far as the current stock market is concerned, it is a discrepancy between the price of a single share of a publicly traded company that deviates drastically from the actual value of any single share. This process allows fundamental analysts to understand whether a stock is under- or over-priced, which is useful for making long-term investments. When a listed stock is significantly overpriced compared to its actual value, we can speak of a possible price bubble, as happened with the tulip bubble in Amsterdam.

Another known example of speculative bubble was that of the DotCom, i.e. the bubble that involved all technological stocks between the end of the 90s and the beginning of 2000, assisted by the advent of the internet. At that time it was possible to see companies go public one day and after a week see double or triple digit increases. Sometimes some stocks failed to make the market due to excessive increases, a real collective folly. The story speaks for itself and the Nasdaq plunged more than 70% in the next 3 years after the bubble burst.

3) The technical causes

Technical causes essentially explain the magnitudes and speeds of market crashes. These are usually (but not always) the result of the above factors, but they are basically the basis for which the saying "you go up the stairs and down with the elevator" exists on the stock market.

Market crashes are characterized by movements very fast and of greater amplitude compared to normal market rises, this is essentially due to the liquidity factor.

When prices fall and the market goes into "sell" mode, we have many sellers who want to liquidate their positions out of fear of incurring huge losses, so buyers will place themselves at very low market levels, knowing precisely that the sellers are willing to liquidate not for technical reasons but for emotional reasons.

Here the sellers are therefore unable to find buyers except at low price levels, therefore prices drop very quickly.

This explains those very fast movements that usually characterize the last stages of a downturn, those where the buyers start to exhaust the sellers on very low price levels and which then lead to what are very important recoveries, both in the short and in the long run.

Original article published on Money.it Italy 2023-03-17 20:33:00. Original title: Perché i mercati finanziari crollano? Le cause