Why did the stock market crash?

Was it inevitable?
When the global economy has been cooling down, and the financial sector in particular has been heading from one cold shower to the next, it was inevitable that stock markets around the world would start catching the chill.
The way in which Asian stock prices responded last week to the fall of the Dow Jones and Nasdaq indices by 4 per cent, hitting a 10-month low, has also punctured a hole in the decoupling argument (which said Asia would not be hit by an America-based problem) that had become fashionable in recent weeks.
Investors around the world have taken note of the fact that the broad-based S&P 500 index is at a 16-month low, along with European stocks. And investors seem to have little faith in the Bush rescue plan's ability to ward off a recession in the US. The Fed will almost certainly respond with sharp cuts in interest rates towards the end of the month, but the market has already discounted for that.
Indian markets worst hit
It is interesting that Indian markets were hit the most, among all Asian markets. This may have been because the correction in the overheated Chinese stock market began some weeks ago. Investors will also have noticed that the third-quarter corporate numbers show significant deceleration in both sales and profit growth, when compared to the same quarter a year earlier.
When coupled with the data showing that the export target for the year will be missed by a wide margin, and that the industrial sector has suffered a sharp slowdown, it was inevitable that stock prices would have to come off their dizzy highs.
What began with profit-booking and unwinding of long positions cascaded on Friday into a 3.5 per cent decline in the Sensex. Foreign institutional investors had moved to the sidelines in the secondary markets even earlier, and FIIs have been net sellers to the tune of Rs 2,200 crore (Rs 22 billion) in January. Also relevant was the Reliance Power IPO, which pulled in a record amount of application money (Rs 1,15,000 crore (Rs 1,150 billion)). Even if a third or a fourth of that was being garnered by sale of stocks, it is a large enough sum for the market to go into correction mode.
There is no doubt that valuations had become expensive. Even after the 10 per cent correction from the market's peak, the Sensex trades at a trailing P/E multiple of 24.5, which is not cheap in anyone's book.
Yet, buying may soon begin
A global liquidity surplus had certainly contributed to momentum buying. The question is whether the correction that has occurred so far is enough for fresh buying to emerge, or whether a further fall is required before value-based buying starts.
On a forward basis, the Sensex trades at an FY09 estimated P/E of 18. The floor therefore would probably be a Sensex level of 17,000-odd -- which would mean wiping out the gains of the past three months, no more. Provided the general economic and corporate news does not get worse than has already been anticipated, fresh buying cannot be very far away.
Indian stocks witnessed their second-biggest fall ever on Monday.
Is everything okay with the economy?
The fundamentals of the Indian economy are still very strong. Some analysts say that business environment is good, but corporate earnings are not as good as they wree last year.
Will foreign investors sell more stocks?
Market expectations are that foreign investors would continue to sell.
With FIIs turning sellers on the domestic bourses, it is likely that domestic mutual funds might step in and buy equity thereby preventing a further fall. However, it remains to be seen if this would happen.
What should traders do now?
"If you have the money it's a great time to buy into this market," said Ambareesh Baliga of Karvy Stock Broking on NDTV Profit. There is no fundamental reason for this massive fall in the market and its been all about margin calls, he added.
Given the rise in volatility, it may not be advisable to trade in stocks that lack liquidity. Trading in stocks, which do not find presence in the derivatives segment may be dangerous.
The reason is simple: derivatives give you an option to hedge your position, limiting your losses, in case the market goes against you.
Keep your trading positions about 30 per cent lower than what you can actually afford. This would greatly help in avoiding distress sale in case the regulators slap additional margins. For an investor, leveraged positions are completely avoidable.
Stock market traders and investors panicked on Monday as the Indian markets crashed.