Crash Anatomy 101: Recognizing A True Crash
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While many of us vacationed, stocks plunged on a day when markets closed early.
Pundits pinned the cause on the omicron variant out of South Africa.
Yet by Monday, all seemed to be forgotten.
But was Friday a crash? A correction? Something altogether different? Over the next month I want to address a few of these questions:
- What does a market crash look like?
- How can I predict the next one?
- What’s the best way to capitalize on a market drop?
We’ll first talk about the differences between pullbacks, corrections, and true bear markets. Then we’ll dig into the history of market crashes, including their causes and frequency.
Pullbacks, Corrections, and Bear Markets, Oh My!People toss around these three (or at least the first two) terms haphazardly. So let’s set the record straight.
- Pullbacks refer to any decline in the market of any amount.
- Corrections refer to declines of 10% to 20%.
- Bear markets are declines of 20% or more.
- Crashes refer to sharp, rapid declines that put markets into a correction or bear market in a matter of days or weeks.
But how often do these market movements happen?
The History of Market DeclinesHow common do you think stock market pullbacks, corrections, and bear markets are?
Before the pandemic, it felt like they were few and far between.
But the data says differently.
First, let’s take a broad look at market declines over the past 76 years.
This data says that we average:
- More than one pullback of 5% per year
- A market correction every 2.62 years
- Bear markets every 8.4 years or so, three of which were considered a “crash”
- Market crashes of 40% or more every 25 years (but they happened in 1973, 2000, and 2008, so were not evenly spaced)
Financial media would have you believe we went straight up in a line.
But that’s not true. We saw many pullbacks and corrections.
Since 2009, the S&P 500 saw:
- Seven corrections of more than 10%
- An additional six pullbacks of 5% to 10%
- Only one year without a pullback of 5% or more (2017)
- A bear market scare at the end of 2018 with a decline between 19.8% and 20.21% (depending on which measurements you use)
Compare that to 2002-2007, a five-year period, during which the S&P 500 saw:
- One pullback of 8.2%
- One correction of 14.7%
But in between, it was smooth sailing.
Now, it seems many people didn’t notice due to the high volatility, but we actually had two significant pullbacks since the collapse in March 2020.
From September to October 2020, the S&P 500 dropped 9.6%.
More recently, we saw a pullback of 5.91% from August to September of this year.
Does this mean we’re out of the woods?
If the prior decade is any indication, we should continue to expect regular pullbacks and corrections for years to come.
What Causes Market Crashes?The data clearly says declines can and do come on a regular basis.
But what causes those once-every-25-year-type plunges?
We know the pandemic initiated the 2020 crash.
A housing bubble led to the Great Recession.
And the dot-com bubble preceded the tech wreck of 2000.
What ties them all together?
I offer you two explanations.
First are what we call “black swan” events. These instances come out of nowhere with little to no predictability.
I would argue the pandemic and the crash in 1987 fall into this category.
Simply put, no one could have predicted them.
Setting those aside, I believe the majority of bear markets and major corrections typically coincide with economic recessions.
The chart below graphs the percent change in the Wilshire U.S. Large-Cap Total Market Index (similar to the S&P 500) over time, with shaded areas showing recessions.
It may seem obvious that recessions can lead to market declines. However, as you can see in 1980, that didn’t happen.
And there’s always the key question. Which comes first; the market decline or the recession?
While we may not be able to predict random declines in the market, we can attempt to predict recessions.
And that’s what I’ll discuss in the next newsletter for this series.
In The Meantime…Keep this in mind: Market pullbacks create amazing opportunities for investors.
Nothing feels better than picking up your favorite stock at a deep discount.
We shouldn’t fear market pullbacks. We should embrace them.
When that big move happens, I want to be prepared.
That’s why I keep my watchlist up to date in TradeSmith Finance.
What stocks do you keep on your watchlist?
Let me know your favorite stock — the one you’ve had your eye on for a while but are just waiting for that pullback to take advantage.