How Likely Is a Stock Market Crash?

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For the past year, investors have enjoyed one of the greatest bounce-back rallies of all time. After the benchmark S&P 500 (SNPINDEX:^GSPC) lost a third of its value in mere weeks due to unprecedented uncertainties surrounding the coronavirus pandemic, it bounced back to gain in the neighborhood of 75% off its lows. You could rightly say that patience has paid off.

But there’s another reality that investors — especially long-term investors — are keenly aware of: the propensity of the stock market to crash or correct. Things might look great now, but the next big nosedive is always waiting in the wings.

It begs the question: How likely is a stock market crash? Let’s take a closer look.

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Double-digit declines occur every 1.87 years, on average

To begin with the basics, stock market corrections (i.e., declines of at least 10%) are quite common in the S&P 500. According to data from market analytics firm Yardeni Research, there have been 38 corrections in the S&P 500 since the beginning of 1950. This works out to an average double-digit decline in the benchmark index every 1.87 years. Since it’s now been more than a year since the market hit its bear-market bottom, the averages are certainly not in investors’ favor.

However, averages are nothing more than that… averages. The market doesn’t adhere to averages, even if some folks base their investments off of what’s happened historically.

We could enter a period similar to 1991 through 1996 where there were zero corrections. Or we could continue the theme since the beginning of 2010, where corrections occur, on average, every 19 months.

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Corrections have been an historical given within three years of a bear market bottom

Another interesting piece of evidence to examine is the frequency by which the S&P 500 corrects after hitting a bear-market bottom.

Since the beginning of 1960 (an arbitrary year I chose for the sake of simplicity), the widely followed index has navigated its way through nine bear markets, including the coronavirus crash. In rebounding from each of the previous eight bear market lows, there was at least one double-digit percentage decline within three years 100% of the time. In aggregate, 13 corrections have occurred within three years following the last eight bear market bottoms (i.e., either one or two following each bottom).

Put another way, rebounding from a bear-market bottom is rarely a straight-line move higher. Yet up, up, and away has pretty much been the theme for investors since March 23, 2020. History would suggest that there’s a very good chance of a move lower in equities within the next two years.

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Crashes frequently occur when this valuation metric is hit

But the most damning bit of evidence might just be the S&P 500’s Shiller price-to-earnings (P/E) ratio. This is a valuation metric that examines the average inflation-adjusted earnings from the previous 10 years. You might also know it as the cyclically adjusted P/E ratio, or CAPE.

As of the close of business on March 30, the S&P 500’s Shiller P/E ratio hit 35.61. That’s well over double its 150-year average of 16.8. Using continuous bull market moves as a parameter, it’s the second-highest reading in its history.

To some extent, it makes sense that equity valuations should be higher now than they’ve been historically. That’s because interest rates are near an all-time low and access to the internet has effectively broken down barriers between Wall Street and Main Street that may have, in the past, kept P/E multiples at bay.

However, previous instances of the S&P 500’s Shiller P/E ratio crossing above and sustaining the 30 level haven’t ended well. In the prior four instances where the Shiller P/E surpassed and held above 30, the benchmark index tumbled anywhere from 20% to as much as 89%. Although an 89% plunge, which was experienced during the Great Depression, is very unlikely these days, a big drop has historically been in the cards when valuations get extended, as they are now.

Image source: Getty Images.

Keep that cash handy in the event that opportunity knocks

To circle back to the original question at hand, the data is pretty clear that the likelihood of a stock market crash or correction has grown considerably. It’s impossible to precisely predict when a crash might occur, how long the decline will last, or how steep the drop could be. But the data strongly suggests that downside is in the offing.

While this might be a disappointing revelation to some investors, it shouldn’t be. Crashes and corrections are a normal part of the investing cycle. More importantly, they provide an opportunity for investors to buy into great companies at a discount. Just think about all the great companies you’re probably kicking yourself over for not buying last March.

The reason to be excited about crashes and corrections is also found in the data. You see, of those 38 previous corrections in the S&P 500 since the beginning of 1950, each and every one has eventually been put into the rearview mirror by a bull market rally. Plus, at no point over the past century have rolling 20-year total returns (including dividends) for the S&P 500 been negative.

If you need further encouragement to buy during a correction, keep in mind that 24 of the 38 double-digit declines in the S&P 500 have found their bottom in 104 or fewer calendar days (3.5 months or less). Crashes and corrections may be steep at times but tend to resolve quickly. That’s your cue to have cash at the ready in the event that opportunity knocks.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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