Crashes happen when everybody starts selling and nobody knows why, so they sell even more.
Companies shorting 130% of a stock doesn't help the market.
In this scenario both the short funds and the retail investors are fucked. A select few retail investors and some of the momentum-trading quants do well. But the majority of the money on either side just evaporates - rapidly.
In a more distant but plausible scenario, this hits a bunch of funds across a bunch of tickers, and it goes systemic. They liquidate their longs trying to survive, and when it's not enough it rolls up into their brokers who are left holding the bag.
If a hedge fund went bankrupt, the cash will go to investors who may be risk averse.
If the hedge fund survives it will have significant losses and probably be cagey about deploying a lot of capital again too quickly because it just stared into the face of death.
In the case of individual investors selling off everything, they might be scared because everything is crashing.
There's no rule that says the money will come back to the market quickly. It depends on investor sentiment. Often things have a V-shaped recovery and things are more or less "fine". We had a few of those over the past few years.
But put it to you this way, if this statement of yours:
It has to go somewhere, and so it will come back into securities in probably a few weeks or max, months. The value represented isn’t exactly disappearing it’s still in the ‘system’.
...was correct, then we wouldn't have crashes. But we do. When fear takes over the money doesn't just come back into the market quickly. And then even if it could, it doesn't because second order effects take over. Small businesses close en masse, etc, which magnifies the downturn until it snowballs into a legitimate recession.
I'm not saying a crash will happen because of this. I'm saying it very realistically can happen.
When stocks drop, excess income and capitol drops, reducing demand in the wider market. Companies come under pressure to cut costs, and end up doing layoffs. This further lowers demand, resulting in a feedback loop.
This is all described by Minsky's financial instability-hypothesis. And Steve Keen has built fully dynamic mathematical models that exhibit the process.
https://www.institutionalinvestor.com/article/b1q3cxqlbmltyl...
Downdrafts and even crashes are called corrections for a reason. They eliminate the weak holders and cause the remainder to carefully evaluate their positions. In the absence of interference, they will be over quickly.
They are a disaster for retail investors on margin. I've never understood why the SEC doesn't gradually increase margin requirements across the board when the market starts to get overheated. (But not once it tops!!)
I think this represents an upgrade from being chased by tigers. Sedentaryism, metabolic syndrome, being fired by the machine, sweatshops, homelessness, addiction, those are downsides from foraging aboriginal lifestyle. But being terrified of losing money is different than being terrified of getting literally eaten.
This is compounded by the fact that funds will defensively sell off (or sell short) stable stocks owned by other funds that look like they're about to blow up. If a fund seems like it's circling the drain and it owns 5% of a ticker, other firms are not going to wait for it to implode and move the price down before they liquidate their own positions in that stock.
This market is terrifying.