The Single Most Important Reason Behind U.S. Stock Market Crash on Monday

While the crash that U.S. stocks had on Monday, which saw the Dow Jones Industrial Average losing as much as 4.60 percent, came as a shock to many, it was actually predicted by a number of professional traders and economists. However, an element of surprise was still present as their predictions said nothing about the exact timing of the crash. Let us explore the whys and the hows of this violent plunge.

The crash had begun one trading session earlier on Friday when the Dow Jones Industrial Average lost 2.54 percent and the Standard & Poor’s 500 Index gave up 2.12 percent. The losses were already sharp but the opening bell on Monday only served as the starting gun for an even deeper plunge that erased all the S&P 500 gains in 2018 and marked the worst single-day drop in the Dow Jones history since 2011.

Despite its massive scale, the drop was described by some analysts as one of the most predictable fallbacks ever. Those who could see it from miles away simply were aware that the stock market cannot continue its highly stable and steady climb forever. Ahead of the fall on Friday, volatility was at record low levels.

The Cboe Volatility Index, which reflects conditions on the S&P 500 Index, was generally moving in a range between 9 and 12 since the end of 2016. Such a long stretch of low volatility was not seen since the inception of the index in 1993. This extended period of stability has placed the stock market on a knife-edge, with investors waiting to react wildly at the first sign of concerns.

Such a sign was provided to them last week in the form of a possible higher inflation this year that could lead the Federal Reserve to push interest rates higher. That, coupled with a statement from Federal Reserve Chairwoman Janet Yellen, in which she said that stock values are high, was enough to push the market of the edge.

This, however, does not explain why the market reached such a state of low volatility and possible overvaluation in the first place. While the U.S. stock market is too massive to be driven by simple few forces, economists believe that it boils down to years of quantitative easing that provided vast amounts of cash to private banks and financial institutions.

1 trillion dollars of government bonds were bought back by the Federal Reserve each year as a part of its economic stimulus program, which got investors quite comfortable with easy money and ultra-low interest rates. That money was spent buying stocks and other assets, leading to a gradual and steady growth in share prices.

Then again, the realization that the Federal Reserve may take a more aggressive approach when cutting stimulus on the back of higher inflation was enough to trigger the selloffs on Friday and Monday.

However, when all is said and done, the drop seen on these two days can rather be considered as a correction instead of a crash.