What Causes a Market Downturn?

A market downturn is when the stock market turns from rising prices to dropping prices. In some cases, it’s a transition from a bull market to a bear market, as was the case in March of 2020. That happens when prices fall at least 20 percent below their 52-week high. But a market downturn can be less extreme. 

“Downturns can happen quickly and sometimes erratically, and sometimes the market can bounce back quickly,” says Skip Johnson, founding partner at Great Waters Financial in Minneapolis. 

If the downturn develops into a bear market, though, the major stock indices go lower over time, hitting new lows and experiencing highs that are lower than before. 

How far do stocks fall and for how long? 

That varies. From 1926 to 2009, the U.S. market experienced eight bear markets, ranging from six months long to 2.8 years long, according to an analysis by First Trust Advisors. The severity of those bear markets ranged from an 83.4 percent drop to a 21.8 percent drop in the S&P 500-stock index. 

On March 11, 2020, triggered by investor anxiety over the coronavirus outbreak, the Dow plunged 5.86 percent (or 1,464 points), sending the index into bear market territory for the first time since 2009. It was a drop of more than 20 percent from February's record high. The S&P 500 and Nasdaq also dipped by 4.89 percent and 4.7 percent, respectively—about 19 percent below their recent all-time highs. By March 12, all three major stock-market indexes had ended the day in bear market territory, with cumulative drops of over 20 percent.

Even though periods of downturn can be scary, they’ve historically just been interruptions in the market’s overall growth. In other words, every downturn has ended in an upturn. And the market has gone on to set new highs. Consider this: According to the First Trust analysis, the average bear market period lasted 1.3 years with an average cumulative loss of 38 percent. But the average bull market, or period of growth, lasted 6.6 years with a cumulative total growth of 334 percent.

So what makes the market drop?

Put simply, a decline in demand for stocks causes prices to fall. “Stock prices are always connected to supply and demand,” Johnson says. “When lots of people want to buy stocks, the prices go up, and when people lose interest in buying stocks, the prices go down.” 

There are a number of reasons why demand for stocks will decrease. Some of the major ones include:

Consumer spending falls. When consumers are continuing to spend money briskly, it’s usually an indicator that interest in buying stocks will also remain brisk. But if consumer spending shifts, that indicates a lack of confidence that the economic good times will last, either for the economy as a whole or their personal situation.

“Most people tend to look at the economy based on their own situation; if they’re doing well and are employed, they’re more interested in buying things and investing in stocks,” Johnson says.

Yield curves on bonds drop. When long-term bond yields start dropping, it’s usually because people are selling stocks to buy bonds. They do this to seek safer investments, which is a sign that investors are losing confidence in the market.

Manufacturing declines. If companies are manufacturing and growing their manufacturing operations, “that says they have confidence in their prospects for growth,” Johnson says. If not, it’s a sign that growth may falter.

The housing market slows, or grows irrationally. The price of housing can be a predictor of market downturns. When housing prices are stable and increasing, the stock market tends to do well. If housing prices increase irrationally, out of touch with their actual value, as they did before the Great Recession, that could signal a coming downturn.

Company profit margins shrink. When public companies are performing well and earning profits, there’s usually not a reason for their stock prices to decrease. But if companies’ labor, material or other costs increase or their sales decrease to the point that their earnings suffer, that could be an indicator that a downturn is coming.

Also, a downturn can occur in specific industries without dragging down the entire market. For instance, commodities such as oil could experience selloffs while other sectors of the market continue to perform well. 

Oil prices jump sharply. The price of oil isn’t a great predictor of the stock market, but if oil became dramatically more expensive, it could have an effect, Johnson says. While oil companies may continue to perform well, U.S. consumers and other industries would suffer.

Can any one of these factors cause a downturn?

It’s rare for one factor to influence demand enough to lead to a market downturn or bear market. The exception would be a major geopolitical event such as a terrorist attack or a pandemic, like the coronavirus outbreak, which triggered a major market sell-off in March. “Those kinds of events can strike up enough emotion to move the market very quickly,” Johnson says. 

What should I do in case of a downturn?

The stock market moves in cycles, so if you invest over the long term, you will likely experience some downturns followed by upturns. The best way to be prepared for the next downturn is to have a financial plan in place and balance your portfolio in a way that is appropriate for your plan. That means understanding how much risk you’re taking and when you will need your money out of the market.

For instance, if you plan to retire soon, and the market is experiencing high volatility or several indicators are pointing to a market downturn, “it may be a good time to be more conservative with your investments,” Johnson says. 

But if you have decades left before retirement—or don’t need to touch the money in your regular investment account for at least the next few years—make sure your portfolio is diversified and lined up with the level of risk that makes you comfortable, and sit tight. 

“Short-term emotional decisions during market drops are a major threat to portfolio returns,” says Martin Schamis, CFP, head of wealth planning at Janney Montgomery Scott. “Diversification helps reduce portfolio volatility. While yearly returns can change, especially based on economic and business conditions, holding a diversified portfolio for long periods increases the likelihood of positive returns.”