It is the 64 trillion dollar question: will there be a stock market crash soon?
Even a relatively accurate estimate of timing could either save you or make you a fortune.
Which active investor has not imagined stepping out of a time machine in October 1929, 1987, or 2007 with a suitcase full of cash?
And what is it that makes October so special?
Without a flux capacitor or a crystal ball, stock market crashes resemble major earthquakes for investment portfolios: we know they are rare and essentially impossible to predict, yet we continue to pay close attention to those who claim they “feel the foreshocks.”
The best approach is to build a solid foundation for one’s investments and to treat crashes the way insurance companies treat natural disasters: know the probabilities and accept that they occur from time to time.
Probabilities
Three astute financial analysts recently attempted to quantify these probabilities.
Victor Haghani and James White of Elm Wealth, who manage capital for demanding clients, asked them, before reading any analysis on crashes, to estimate the probability of a 30% decline in the S&P 500 within the next 12 months.
The average of the responses was 31%.
A long term study by Yale economist Robert Shiller reaches a similar conclusion.
But words are cheap. Those who risk real money through the options market assign only an 8% probability to a crash, according to Elm’s calculations.
Steven Blitz, chief U.S. economist at TS Lombard, agrees that 8% to 10%, that is once every 10 to 12.5 years, is the historical probability and a realistic estimate.
The last crash occurred just six years ago, when the Covid-19 pandemic paralyzed the economy.
That, however, does not mean we are in the clear.
Misery index
Without predicting a new crash, Blitz points out that such events occur more frequently when the Misery Index (inflation plus unemployment) rises, as it is doing today.
The period 1966–1982, for example, was particularly prone to crashes, while the following 18 years were not.
Negative trends can make stocks cheaper relative to the economy.
If this is combined with the fact that stocks have rarely been as expensive as they are today, the probabilities of a crash this year could be even higher.
Both the options market and insurance companies may be good at calculating the average probabilities of an event, but sometimes bad events come in waves.
In such cases, the protection they offer is sold far too cheaply.
Perhaps the most interesting conclusion is not the slightly increased probability of a crash, but the way those who read Elm’s entire analysis on the frequency of crashes reacted.
Those who made a second estimate continued to believe that the probability of a crash within the next year is 15%.
This could cost them.
As the leading fund manager Peter Lynch once observed:
“Far more money has been lost by investors trying to anticipate corrections or to ‘time’ the market than has been lost in the corrections themselves.”
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