A Crash Is Very Unlikely

| About: SPDR S&P (SPY)

In the spring of 1988, when I was still a young finance professor, I attended a research seminar about the market crash that had occurred just a few months earlier. On October 19, 1987, a date that became known as Black Monday, the Dow Jones Industrial Average plunged 22.6%, its largest decline on any single day. The speaker at the seminar argued that investors were unprepared because they thought that a crash of such magnitude was extremely unlikely. He didn't appreciate it when I suggested that investors were right to think that way. After all, the second-largest decline in history had occurred back in 1929. On October 28 of that year, the Dow had fallen 12.8%. A super-crash once every 58 years seems like an unlikely event to me.

Even though market crashes are rare, many investors believe they are not uncommon. Perhaps, that's because there is always one pundit or another warning that the next crash is just around the corner. And because the media love extreme views, these doomsayers get plenty of airtime on TV and coverage elsewhere.

This is why I was fascinated when I came across a National Bureau of Economic Research (NBER) working paper titled "Crash Beliefs From Investor Surveys." The authors, William Goetzmann of Yale University, Dasol Kim of Case Western Reserve University, and Nobel laureate Robert Shiller of Yale University, find that investors do not underestimate the probability of a severe market crash at all. On the contrary, they routinely overestimate this probability. The authors asked investors what probability they would assign to a crash similar to Black Monday or the crash of '29 happening within the next six months. The median response was 10%. However, an analysis of the historical data suggests that the actual probability of such a selloff occurring within the next six months is only about 1.7%.

Why are investors so wrong about this? To a large extent, the authors blame the financial media. They document that the media give more coverage to stock market downturns than they do to stock market rallies. Furthermore, they find that investors suffer from an "availability bias." In other words, investors are strongly influenced by recent events that are still fresh in their minds. This availability bias combined with the media's extensive coverage of market downturns causes investors to regularly overestimate the probability of a stock market crash.

The S&P 500 is up 8.6% since the initial selloff following Brexit. As my regular readers know, I believe this rally is unjustified. Economic growth may be picking up a tad, but it is still extremely anemic. Earnings season is just getting underway, and the results so far are mixed. And political and economic results of recent events, such as increased terrorist strikes overseas, killings of police in the U.S., and a military coup attempt in a NATO country, will likely increase the cost of conducting business all around the world.

I don't believe the market is grossly overvalued. While I would assign a significant probability to a second market correction happening before year end, unlike the participants in the NBER study, I think there's only a small chance of a market crash happening anytime soon.