Now, this may surprise some of you given the negative slant of what we’re talking about today (stock market crashes aren’t exactly fun), but I love this question because I get to totally nerd out on one of my favorite topics.
🎬 WATCH: What Causes a Stock Market Crash?
On top of that, I love this question because you are, in essence, asking me to predict the future—is that even possible? Well, I’ll talk about that here in a minute. Because fundamentally, if you want to know what causes stock market crashes, I'm assuming you also want to know what avoids them. So, if you’re an investor who is ready to dive into the markets, you’re in the right place.
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Heck, there’s a good chance you are guided by the mantra we’ve all been programmed by pop culture to embrace, “buy low, sell high.” You just want to figure out where that “sell high” level is and get out, so you can take your profits before the market crashes. I get it, I fully understand it. I've tried it myself. But here's the truth—I cannot predict the future when it comes to the stock market. Neither can you, and neither can anyone else.
It's important to stay wary of those who claim, “Hey, I know for a fact the market's going to crash next week, next month, next year!” They simply cannot know this with any degree of absolute certainty. It cannot be done. But we can look back, study history, study data, study facts, and get an idea of what caused past stock market crashes to get an idea of what can cause or could cause or might cause the stock market crashes of the future.
When stock markets get extremely overvalued and there is a catalyst—when those two things come together, then we typically have a stock market crash.
The big examples many often look to (and understandably so) are the crashes of 1929, 1973, 1974, 2008 to 2009. But the 2000 to 2002 market and the 2020 market highlight the effects of a catalyst event. In 2000, we had a recession. In 2001, we had terrorist attacks. In 2020, we had the COVID-19 pandemic.
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Where most folks make a mistake is looking for a sole cause of a stock market crash. Stock markets are too complicated for there to be a single reason. The U.S. economy is made up of hundreds of millions of people, with every single one of us influencing a piece of it—and the stock market's a big giant scoreboard of the economy. The entire system of how our economy and the stock market work together is way too complex to say that one event caused its downfall—that would be oversimplifying the matter.
Our investment team watches a whole string and a list of other data measurements, but the Buffet Indicator is one of the easier ones to describe.
From our March 2024 market trends update
The Buffet Indicator is simply the total stock market capitalization as compared to the U.S. GDP. And when that level gets around two standard deviations above its historical trend line there, we see crashes happen. Take, for example, 1973 with two standard deviations, 1999 with two standard deviations, 2022 with two standard deviations.
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In 1973, you had massive oil market disruptions, or energy market disruptions that became the catalyst for the '73-'74 crash and the lost decade of the 1970s. And again, in 1999-2000, you had a recession; in 2001, we had terrorist attacks. Each were catalysts for a massive selloff in the market and the beginning of the lost decade.
Now, in 2008, we did not have two standard deviations of overvalued, but we had a massive debt crisis and real estate crisis that triggered a massive market selloff that was in the middle of the lost decade. We also were still dealing with the lingering “hangover” effects of what happened from 2000 to 2002.
In 2020, we had two standard deviations above its historical trend line. The stock market was the most overvalued U.S. stock market in history as compared to the GDP. The pandemic was, without a doubt, a massive catalyst. You had more so in history, the two triggering events that you needed for an absolute stock market debacle—and over three weeks, we got a 38% sell off in the U.S. stock market.
What happened then? Professionals sold immediately, took profits, got out of the way. So, why didn't we just have a massive crash? Well, the Federal Reserve leadership, those guys are economists—and they also study their history. They knew exactly what could happen. So, they turned on the United States printed presses and flooded both the economy and the markets with more money than we've ever seen flood into the economy or the markets. By many estimates, over $5 trillion hit the street in over five months.
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That’s why we didn’t have a market crash. That's why we, instead, had a V-shaped recovery—and that is the only reason we had a V-shaped recovery. So, this would be a good place for us to consider how we can protect ourselves as investors, and what warning signs we should be watching out for.
Well, the number one way to protect yourself is you must manage risk. In the lead up to all of these markets, you had massive growth in both the economy and in the markets. Whenever we see massive growth like this, you can bet you have investors driven by a fear of missing out, i.e., FOMO.
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When the fear of missing out takes over, investors start chasing investments that make no sense—their friends have made money or they've read about what's going on in the markets, and they don't want to miss out. Then when the markets sell off, they fear loss and sell off accordingly. In fact, many studies show that we feel the pain of loss two times more than the enjoyment of gain.
This is exactly what you don’t want to do. Again, none of us can predict the future when it comes to the stock market. But you can control the quality of the financial plan you create, and the investment plan you put in place to support it. You never want to be in the position where you keep score with money; that’s how you get sucked into those massive bubbles that turn into a stock market crash.
What causes a crash is overvalued levels in the stock market. Look up the Buffet Indicator, as we do. With it, you can watch historical trend lines and see how the stock market's valuation is compared to those historical trends.
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The math almost always checks out in this way. It's going to return down to that trend line or it's going to grow up above that chart to that trend line. That's just how it works, and it leads you to recognize why the number one rule of investing is to manage your risk to avoid large losses. And if you need help or have questions about what this looks like for your specific situation, please don’t hesitate to reach out to schedule a conversation with us.