Last Updated on May 6, 2021
A lot of economists and analysts talk about the stock market crash as if it will happen tomorrow. Investors caught in a stock market crash very often make emotional decisions that do not go in favor of their investing strategies.
What you can do is find out about past stock market crashes, see what led to them and what the market looks like today. This is what we will go through in this article, after which you will be somewhat better informed about what you could do.
What Is a Stock Market Crash?
A stock market crash is a major decline (about 20%) of stock prices resulting in a large loss of wealth. Crashes are often caused by economic bubbles and economic factors. Moreover, they are further deepened by the panicked sale of investors.
Similarly, they come with economic recession and high unemployment. However, they can also be great buying opportunities for investors.
If we look at it simply, there is a period of optimism (bubbles) in which people borrow money they don’t have to spend it. There is also a period of pessimism (recession) in which people have to repay the money they borrowed and spent.
I highly recommend watching a video of famous investor Ray Dalio. He put together this whole philosophy in 30 minutes. I assure you that after this video a lot will be clearer to you.
Previous Stock Market Crashes
Those who do not remember the past are condemned to repeat it.George Santayana
I think this quote says why it is important to be familiar with previous crises that have occurred. As a result, we will go through the major crises that have happened through humanity and see what you can learn through them.
The Great Depression in 1929
It is considered the biggest market crash in history. You must have heard of Black Thursday and Black Tuesday when this market crash happened. These crashes triggered economic depression which began in 1929 and lasted until 1939.
How did this happen? Well, throughout the 1920s, the U.S. economy was in a period of optimism. Nation’s wealth more than doubled. Everyone was involved in the stock market and buying stocks, both those who knew and those who knew nothing about it. A stock bubble began to form.
On October 24, 1929, “Black Thursday” happened. Investors began to sell their overpriced stocks and Dow Jones Industrial Average dropped 11% with a large volume of trading.
Five days later, on October 29, nervous investors started to sell again. This was another panic selling where investors traded a record of 16.4 million shares, known as “Black Tuesday”.
For the next three years, the market continued to crash. Recovery began in early 1933 and some historical charts show that it took more than 25 years for the market to recover. In other words, if you bought shares at the peak of 1929, you could sell those shares at that price in 1954.
The mistake that happened during the Great Depression and cannot be repeated today is the increase in interest rates. The U.S. wanted to stop the appreciation of gold and therefore raised interest rates. Consequently, businesses stopped taking loans, creating even higher unemployment and a collapse of the economy.
Humanity is smarter now and things are different these days. Gold is not pegged to the dollar, bank money is secured and we know that interest rates are declining in times of recession.
Black Monday (1987)
Black Monday is the name of the unexpected market crash that happened on October 19, 1987. Dow Jones Industrial Average fell 508 points (22.6%). It was the highest one-day drop by percentage in the index’s history.
People thought another period of depression was beginning in 1929. However, the stock market recovered in less than 2 years. Shares of investors who did not sell their shares soon regained their value.
Also, those who invested when the market fell, earned a very good return.
It is thought that the cause of the crash was caused by the computer. More precisely, program-driven trading models that followed a portfolio insurance strategy as well as investor panic.
Today, a trading curb is a temporary restriction on trading in a particular security or market, designed to reduce excess volatility
As protection against this event, today there is a trading restriction which is a temporary restriction on trading in certain securities or a market, designed to reduce excessive volatility.
Dot-Com Bubble in 2000
You have probably heard of the dot-com bubble, or dot-com boom, or tech bubble, and even internet bubble. These are all names for the market crash that happened in 2000.
In the late 1990s, a period of the massive growth of internet-related companies happened. Everyone believed that internet-connected companies would achieve tremendous growth in the future and kept buying them.
The peak was in March 2000, and just one month later, the NASDAQ had lost 34,2% of its value. These days, the bubble burst.
Stock Market Crash of 2008
The stock market crash of 2008 happened on September 28, 2008. It is considered to be the biggest financial crisis since the Great Depression in 1929.
This financial crisis is known for the bursting of the United States housing bubble which caused the values of mortgage-backed securities tied to American real estate to plummet.
Consequently, financial institutions have suffered huge losses, unemployment has risen, distrust in financial institutions, and slow economic activity.
The stock market recovered in 5 years which is neither good nor bad.
Stock Market Crash of 2020
When the world began to enter a lockdown, the stock market began to fall sharply. The crisis of 2020 was led by covid 19.
People did not know what was happening or what awaited them. We all encountered this situation for the first time in our lives.
Over a three-week period, S&P 500 fell 31%. However, there was a rapid recovery of the market. In just a few months, the shares returned to normal, and today they have already far surpassed the then all-time high.
What Is Happening Today?
Today we have stock market at all time high. Is the stock market overvalued? One could only guess.
What you could learn from previous stock market crashes is that it is hard to predict falls as well as their recovery. The stock market is swinging from a zone of pessimism to a zone of optimism and vice versa.
To get a clearer view on the market we will measure the it with various indicators such as P/E ratio, P/E ratio and Buffet indicator. These indicators will show us if the market is overvalued.
Buffet indicator takes total market capitalization divided by the US gross domestic product (GDP). The most common measurement of the total value of the US stock market is the Wilshire 5000.
It is logical that Total market capitalization will move higher as long as GDP continues to grow higher.
If the total stock market gets too high relative to the size of GDP, market is becoming overvalued.
GDP has continued to struggle during the coronavirus, while the total stock market continued to achieve all-time highs. According to the buffet indicator, the stock market is overvalued.
Stock Market Indicator – P/E ratio
Price to earnings multiple is best used on S&P 500 index. It is a ratio that measures its current share price relative to its per-share earnings (EPS).
As you can see from the graph below, S&P 500 P/E ratio is currently 44,38x. The average S&P 500 ratio from 1900 till today is 16,45x.
The highest S&P 500 P/E ratio was during the stock market crash in 2008 when it was 70.91x. Also, noticeable is the peak in the crisis in 2002 when the P/E ratio was 46.17 and in 1987 when it was 18.01.
What can partially justify the growing P / E ratio today are the low interest rates that don’t actually give much room for investment. In addition, savings in banks do not pay off. As a result, investors will invest more in the stock market, which further leads to an increase in stock prices.
Furthermore, coronavirus has affected earnings that have fallen due to reduced economic activity, which further increases the P/E ratio.
It is difficult to say what will happen in the future, but it should be taken into account that the market is quite inflated at the moment looking at the P/E ratio. Whether the pandemic will pass soon and thus increase the company’s earnings, and consequently reduce the p / e ratio, remains to be seen.
Stock Market Indicator – Shiller P/E ratio
Shiller’s P/E ratio takes average earnings over time and adjusts them for inflation. This ratio shows whether the company is growing more than inflation or is just keeping with it. You want to see earnings higher than inflation.
Shiller’s P/E ratio as well as the other two ratios show the highest numbers in history.
Average Shiller’s P/E ratio from 1900 till today has been 17,5x.
The highest level was in tech bubble 2000 when Shiller’s P/E ratio was 43,77. Many companies were overpriced and they had no profits at all.
Late 1970s and early 1980s show lower ratio as P/E ratio. This is due to interest rates and inflation which was on higher levels back then.
In this article, we went through what a stock market crash is and what the biggest crises are. How they came about and most importantly that each is special in its own way.
It is hard to predict the stock market crashes as well as their recoveries.
Using three stock market indicators, we analyzed the current market. These are the P/E ratio, Shiller P/E ratio, and Buffet indicator. Each of these indicators showed how the market is at its highest levels.
Still, if the stock market is overvalued now, no one can say whether the stock market will grow another 10, 20, or more %. No one can say if it will grow like that for a few more years.
Given the above, I think it’s worth being smart about how to invest. What you can do is look for individual companies that do well. These can also be individual sectors followed by certain ETFs.