What Happens When Markets Crash?

By many metrics, US stock markets are overvalued. Nobody knows when the next crash will come, but history suggests when irrational exuberance pushes prices above fundamentals, a correction can suddenly happen. The question is if there is a stock market crash in 2026 or 2027, how would it affect you?

A good question to ask upfront, is the AI bubble reminiscent of the 2008 credit crunch? On the one hand in 2026 we have asset price bubble in terms of housing and stocks. There is excessive leverage and debt in the system. In 2008, it was credit default swaps, today it is growth of private equity. There is a degree of over-confidence in markets. Housing costs are higher than the peak of the 2007. There are also inflationary pressures from oil prices, tariffs and AI itself. As a result markets are pricing in interest rate rises.

However, in 2026, there are also important differences. The bad debts of AI and private equity are nothing like the sub-prime mortgage defaults of 2008. Banks are much less exposed in 2026 because of new regulations.

Also the truth is when we think of US stock prices being overvalued, we are really thinking of the tech stocks, which have seen the most rapid growth. Outside Nvidia, there are some really speculative valuations on the growth of AI revenue in the future. If these fail to materialise, we could see tech stocks drop dramatically. And SpaceX valuation which runs at 117 times revenue, will be particularly hard hit. But a crash in tech stocks will be different to a crash in all shares. The AI bubble may pop, but it can just lead to a fall in market concentration amongst tech stocks.

Also, whilst companies like OpenAI may struggle to justify spend and valuation as users switch to cheaper Chinese models, it is worth pointing out that AI is not just about speculative mania. There is a significant rise in actual revenue. But the problem is the levels of investment are so large, this revenue growth will need to continue to accelerate to unprecedented levels.

Goldman Sachs estimate AI will create between $10- $20trn of discounted. But markets have priced in $27trn of additional value creation. So, the size of the “bubble” is now between $5trn – $17trn. That’s a big potential crash.

Now stock market crashes can precipitate recession. In fact the Wall Street Crash of 1929 was the starting point for the Great Depression, a decade of mass unemployment, falling output and economic disaster. In the late 1920s, there was so much irrational exuberance at rising share values, people borrowed to buy shares, so when prices fell, many went bankrupt, causing a cascade of defaults through the economy.

The credit crunch of 2008 saw a big drop in share prices as the housing bubble burst. When Lehman Brothers was allowed to go bankrupt, the stock market went into free fall. This had a dramatic effect on reducing bank lending, lower confidence and the economy fell into a deep recession. But it was also at this point that governments and Central Banks intervened. Banks were bailed out and Central Banks created money, injected liquidity into the financial system However, the issue with the credit crunch is that the losses couldn’t be papered over — banks lost so much from bad loans that it led to a deep recession.

An underappreciated issue is how does the government and Central Bank respond to a stock market crash. When shares boom and traders gain big bonuses, everyone loves the free market, but when shares crash, there is often pressured to socialise losses or intervene to halt contagion.

It’s very important to bear in mind, not every stock market crash causes a recession. As economist Paul Samuelson said, the stock market successfully predicted 9 out of the past 5 recessions. Sometimes shares can crash in value and the result is really quite benign. The best example is the stock market crash of 1987 — a 25% fall, dramatic declines. But it was really short-lived, prices rallied, and if you held your nerve, you would soon recover losses. There was virtually no negative effect on the economy. The crash was actually quite hard to understand, driven more by low liquidity, rather than a major underlying cause. Even the dot-com bubble bursting in 2001 only had limited effect on the actual economy. But the dot-com bubble did see some speculative internet firms wiped out.

So when a crash does happen, how does it spread into the wider economy? When the market falls, investors see a decline in wealth, confidence falls and as a result some people cut back on spending. Now you might say, I don’t own any shares and the rich who do buy shares can afford to lose paper money. This is true up to a point. But if you have a private pension, you will probably have exposure to the stock market, whether you like it or not. A sustained fall means a smaller pension, and that might encourage you to save more.

Shares on the Margin

In the UK, there is much less exposure to the stock market, as people tend to prefer cash savings. But in the US there has been a boom in share buying. Retail investors now account for 20% of trading compared to 10% in 2011. Young people locked out of the housing market have switched to buying shares, and in recent years they have enjoyed dramatic gains. This means more ordinary households will be affected by a share crash. Furthermore, there has been a rise in buying shares on the margin. This means using borrowed money to fund share buying. This is a critical point for why a stock market crash can cascade through the economy. If you borrow money to buy shares, but shares fall in value, then this is often a trigger forcing people to sell, causing further declines in share values.

Also, if the stock market falls, it will be harder for some businesses to raise funds for current investment. In the US, economic growth has been boosted by a boom in investment on AI data centres. In the past firms could spend revenue to fund investment, but now they have reached tipping point of needing to borrow to fund investment. But a stock market crash will make it harder to raise finance. Investment will fall, and this will have a negative multiplier effect on other areas of the economy.

Also many ordinary workers are currently seeing real wage falls, not helped by high inflation and the ongoing trade war. So there is underlying economic weakness, with the economic spending propped up by the top 10% richest consumers, who would be affected by falling share prices

Also a stock market fall would affect private equity. Private equity has boomed in recent years. It is a $2 trillion market that barely existed before 2008. But private equity is less transparent and less liquid, a stock crash would lower valuations of private equity, which is a problem when private equity is based on leverage. Even before a crash there are warning signs from private equity struggling to refinance.

Another perspective is that a stock market crashes is not all bad. Historically, the stock market has shaken off crashes to recover losses. For long-term investors, buying good value stocks with a good track record of profit usually pays off in the long run. Secondly, stock market crashes can give savvy investors the opportunity to buy better value stocks. Thirdly, for all the talk of a bubble, profit earnings are growing quite strongly. Now profit earnings on their own doesn’t mean you can’t have a crash — it is worth bearing in mind earnings per share were often quite good even before previous crashes.

The final food for thought, there is a theory, that when one bubble burst, speculative capital moves to another area. When Japanese bubble burst, we saw capital flee to South East Asia, we’ve then had Dotcom, housing bubble, and now tech/AI bubble.  When there’s a crash in one area, it moves somewhere else. Human psychology always likes to think this time is different. Anyway, perhaps it will be different with Space X. Fancy buying into a $3 trillion worth company with $5 billion net loss in 2025, check out this video.

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