It is a topic that is as old as the post-financial crisis period itself. When will the inevitable crash in today’s U.S. stock market finally arrive? The short answer? It’s not going to. In my view, today’s stock market is likely to never crash. The following are the reasons why.
About A “Crash”
The word “crash” gets thrown around all of the time when it comes to the stock market (SPY). The same goes for words like “bubble”, “crisis”, “Armageddon” and “doomsday”. I would contend that all of these words get used far too often when it comes to stock investing.
A stock market “crash”, of course, is defined as a sudden and sharp decline of stock prices across most, if not all, sectors of the broader market that results in the sustained and significant loss of portfolio values and investor wealth.
Is this “crash” scenario as it is defined the most likely outcome directly ahead for the U.S. stock market? Absolutely not at all, in my view.
So does this mean I am predicting the stock market is going to continue rising indefinitely into the future? Of course not. A point that can often become lost on many investors is that a vast range of market outcomes that exists between a bull market rising unabated to the sky and the stock market suddenly falling off a cliff. Just because I do not think today’s stock market is destined to crash does not mean I do not think it will eventually peak and start to go down.
Instead, one outcome for today’s stock market that I can say will happen with near absolute certainty is that the bull market will end. Exactly when it will end remains unknown, but it will almost definitely come to an end.
The fact that it is already running much longer in duration than average as the second longest bull market in history suggests that such an end could come sooner rather than later. On the other hand, bull markets do not die simply from old age alone, so it is also possible that it could end up becoming the longest by far before it’s all said and done. Of course, looking beyond old age at the fact that stock valuations are also near their highest in history suggests that today’s market has its work cut out for it to continue running indefinitely into the future, particularly once the seemingly endless torrent of liquidity flows from global central banks finally ends and starts to get drained off over the course of the coming year. But regardless of whether it comes in the next few months in early 2018, over the course of the next couple of years through the end of the decade, or more than five years from now early in the next, the one thing we do know is that today’s bull market will finally end, a new bear market will arrive, and investors will face the prospect of absorbing losses to the value of their investment portfolios.
Reflections On The Past
So if today’s market is not likely headed toward a crash, what then is its likely fate once the stock bull finally expires?
To help answer this question, it is worthwhile to reflect on the past three notable bear markets to gather perspective.
Let’s first take a look at the unwinding of the technology bubble from early 2000 to early 2003. This was the bear market that came in the aftermath of one of the most speculative “bubbles” in stock market history that was heavily concentrated in the technology (XLK), media (PBS), and telecom (IYZ) sectors that the time. Unlike today’s stock market and much like today’s cryptocurrency market, tech stocks in the late 1990s into the turn of the millennium were in a true “bubble”. And it also came with nary an economic slowdown outside of a short and shallow recession that came and went in 2001 in the midst of the unwinding process.
This was a staggering bear market for many investors caught up in the tech bubble frenzy. But it was not a crash. The declines were neither sudden nor sharp. And its impact was not broadly felt across stock market sectors, as nearly every other major stock market sector outside of technology was flat to higher from the start of the S&P 500 Index bear market in early 2000 through the summer of 2002, before the rest of the market finally capitulated. And a loss of value in these other sectors lasting less than a year cannot be considered a sustained loss in portfolio value.
Was it a “crash” in the tech sector? Absolutely, as the chart of the NASDAQ (QQQ) and the Technology sector SPDR relative to the S&P 500 Index (IVV) below over this time period will attest. But for those invested outside of the technology sector, it could better be described as a solid bear market and nothing more than that.
What about the financial crisis? Wasn’t this a crash? After all, it was the most distressing capital market episode since the Great Depression, and nearly resulted in the collapse of the global financial system.
The answer here is "not initially". The stock market first peaked in July 2007. It reached its final peak in October 2007. And for most of the next year, it went adrift, with a successive series of lower lows followed by lower highs. But through September 2008, the market was down less than -30%. A solid bear market by most standards, but nothing that could be described as sudden or sharp. As to whether the decline was broadly based, the energy (XLE) and materials (XLB) sectors were solidly higher, consumer staples (XLP) were also in positive territory, healthcare (XLV) and utilities (XLU) were only marginally lower, and cyclical sectors like consumer discretionary (XLY) and technology were just crossing into bear territory. Instead, the only real crash-like pain was being felt in the financials (XLF), which were down more than -40% at that point.
It was only at that point in October 2008 that a crash finally arrived. What was the primary catalyst? While the rot in the system had been accumulating for years, the spark was the policy decision to allow Lehman Brothers to fail, followed by Washington Mutual, while having Merrill Lynch and Wachovia absorbed by Bank of America (BAC) and Wells Fargo (WFC), respectively, with companies like AIG and Citigroup (NYSE:C) on the brink. It was only at this point in October 2008, when market liquidity evaporated, along with the piling up of failures on Wall Street, that the market finally crashed. And over the next five months, it dropped precipitously and broadly, before reaching its final bottom in March 2009.
This raises an important “crash test” question to consider in regard to the financial crisis. What if policymakers never allowed Lehman and Washington Mutual to fail? What if they propped up Merrill Lynch and Wachovia? What if they intervened earlier in the case of AIG and Citigroup? Policymakers certainly would do so without skipping a beat today, so what about back then? At a minimum, the market likely would not have crashed. In many respects, it was the difference between ripping the Band-Aid off versus slowly peeling it away. Had the latter outcome taken place, the market would have likely continued grinding lower through 2009 into 2010, before finally bottoming out. As for the subsequent recovery from such a scenario, this too might have also been more muted, as the detritus would have remained in the global financial system in the process. We will never know, thanks to what some might describe as the policy mistake of allowing Lehman Brothers and others to fail (others might call this allowing the free market to run its course, but this is a topic for another article on another day).
So was the financial crisis a “crash”? Not initially for the broader market. It was a crash for the financial sector, and it likely would have eventually spilled over to bring lower the broader market, just as the tech sector had done six years earlier in 2002. Instead, it became a crash due to the lack of action from policymakers roughly one year after the bear market was already well underway.
What about the worst day in stock market history? This, of course, took place on Monday, October 19, 1987, when the U.S. stock market as measured by the Dow Jones Industrial Average (DIA) shed -22.61% in a single trading day.
Now that’s a “crash”. It was sudden. It was sharp. It was broadly based across sectors. The loss in portfolio value was sustained for a reasonable period of time. And the causes attributed to the crash included program trading (see high frequency trading today - check), overvaluation (historically high valuations today - check), and a drying up of liquidity (not yet, but with global central bank stimulus drawing to a close, it could be looming).
But even with this epic past episode, it is worthwhile to put it into some context.
First, it is true that the decline was dramatic, but the result was nothing more than the market giving back the tremendous gains it had accumulated over the past year. For example, had an investor bought the S&P 500 Index on November 1, 1986, and vanished for a year, only to return on November 1, 1987, immediately after the crash, they would notice no discernable difference in their portfolio value.
Second, it did take about two years for the stock market to recover the losses it sustained over a very short period of time in October 1987, but the market began making its comeback almost immediately following the crash.
Third, and perhaps most importantly, this crash brought with it the birth of the “Fed put” that was in October 1987 completely unknown but today is accepted as a given and explicitly assumed to be in play on every given trading day. Put more simply, policies are now in place that were not in 1987 to prevent a similar style one-day market collapse from happening again to this extreme magnitude.
So yes, the 1987 episode was a crash. But that was thirty years ago. And a lot has changed since then to prevent something like this from repeating itself to this extreme, even despite some of the similarities in underlying characteristics versus today. Even under this traumatic scenario, it came in the wake of strong gains up to that point, and the market immediately started making its way back to the upside following the fall.
If Not A “Crash”, Then What?
Considering this recent historical perspective, what should we reasonably expect the next time around?
First, not a crash. Could we see a series of flash crashes as the short-term seizing of liquidity causes major dislocations in asset prices on any given trading day going forward? Certainly. But one thing we can be completely confident in is the fact that monetary policymakers will come rushing in at a moment’s notice to douse any capital market fires with a massive fire hose of liquidity and reassurances that more help is on the way, if needed. Heaven forbid, after all, that investment markets feel any degree of sustained stress any more.
Instead, the next bear market is likely to unfold as follows. It is likely to begin very slowly with a sharp move to the downside lasting a handful of trading days, if not a week or more, that takes anywhere between -7% and -12% off of the broader market indices. Even if monetary policymakers stay relatively quiet as such an event unfolds - which would be an exception for the Fed, as down -7% has typically been the limit of its comfort zone before it starts looking for microphones to start jawboning - the market likely has a sufficiently large number of participants that are bound to view this correction as the first real "buy the dips" opportunity to get into this market in some time. And thus, stocks will rally to the upside.
But instead of rebounding to new highs, the market will fall short and start to roll back over. While subsequent declines are likely to be shallow and subsequent rallies frequent, it would involve the market entering into a progression of setting sequentially lower highs and lower lows. For the first time in nearly a decade, the dip buying would start to go unrewarded from a long-term investment perspective, as the pain would start to slowly accumulate.
Eventually, the market would slowly begin to pick up steam to the downside. But given the regularity of the rallies, many market participants would likely still view what was unfolding as nothing more than a healthy stock market consolidation after years of post-crisis gains instead of any new bear market scenario. This, of course, is precisely how so many investors find themselves trapped in the jowls of a bear market, for they dismiss the potential for a more sustained downside risk scenario until it has become far too late.
Unfortunately, the next bear market is not likely to replicate the Band-Aid ripping episode that took place with the financial crisis. Instead, once central bankers realize what is unfolding is a new bear market, they are likely to fight it at every possible turn to prevent it from moving further to the downside. This will likely be reassuring to investors who have become conditioned to the thought of “don’t fight the Fed”, but here’s the problem - once the momentum gets moving in either direction in the stock market, it becomes difficult to arrest it and turn it back in the other direction.
Case in point: The U.S. Federal Reserve began cutting interest rates in January 2001, just a few months after the final tech bubble peak in September 2000. Over the course of the 2001 calendar year, the Fed lopped 4.25 percentage points off of the Fed Funds rate. Yet, the bear market that was already underway at that point had more than another year to run to the downside, with some of its most staggering losses ahead in 2002, before it finally bottomed out.
Another case in point: The U.S. Federal Reserve began cutting interest rates in September 2007, about three weeks before the final bull market peak in October 2007. And over the next 18 months, the Fed took interest rates 4.75 percentage points lower to the zero bound and started buying assets with reckless abandon before the market finally bottomed out.
The bottom line: The Fed and other central banks may have a track record of winning the capital markets war in the end, but it often is not without significant portfolio bloodshed first.
Returning to our future scenario, the Fed has accumulated roughly 1.25 percentage points of rate cutting fire power to date. They are likely to add another 25 basis points in December, and may even get away with another 75 basis points in 2018. But even under this optimistic scenario, the Fed will have relatively less ammo to combat the next bear market. As for the once-extraordinary and now inevitable future asset purchases, the Fed will be starting with a balance sheet still north of $3-4 trillion, which is vastly bigger than the roughly $800 billion balance sheet it had heading into the financial crisis.
Thus, the Fed will indeed try to fight the downward momentum at every turn, but it will likely lack the power to do so effectively. Thus, the progression of lower highs and lower lows continues until the market, finally at minimum mean, regresses back to its historical average valuation, if not lower - after all, markets are classic for overshooting dramatically in either direction, before finally coming to a stop and heading back in the other direction.
But because the Fed and other global central bankers will likely be inclined to fight the decline at every turn, yet will lack the monetary firepower to do so effectively, it is likely to result in the next bear market lasting much longer in duration and feeling more grueling in magnitude to many of its "buy and hold" index participants than any previous bear market in recent memory.
Put more simply, once it gets going, it is likely to be anything but a crash. Instead, it is likely to be slow and shallow and potentially seemingly endless, with many slides lower followed by equally many bounds to the upside of relatively weaker magnitude. In the end, such an outcome has the potential to become the long-overdue washout cleansing that today’s market so badly needs to bring the U.S. economy and its markets to the next great secular growth phase.
The Sky Is Falling! Bwak! The Sky Is Falling!
Umm, no it’s not. The sky is never falling. The sky might seem like its falling only for those investors that are completely unprepared from a risk control perspective. Otherwise, investors should look at any future bear market like the one that has been described here with an eye toward opportunity, perhaps just as much, if not even more so, as they would a raging bull market.
Let’s recap what’s been said here so far. Today’s stock market is not likely to crash. And the start of any new bear market does not loom as imminent on the market horizon. Also, any future bear market, once it starts sometime over the next few years, is one that is likely to be marked by more gradual declines with associated rallies along the way over a much longer duration than past bear markets. This outcome will likely be thanks to the continued intervention at all costs by global central bankers throughout the episode.
So how does an investor succeed under such a scenario?
First, not by relying on a passive index strategy.
Instead, it is by focusing on active management. It is often said that the 1970s were among the best times for active management. Why? Because a grueling and prolonged bear market was taking place at the time that forced investors to work hard at capturing upside return opportunities. But those who were willing and able to effectively put in the work were rewarded for the effort. The same was true during much of the unwinding of the technology bubble in the early 2000s. It was also true during the first year after the market peak in 2007, until policymakers got involved. And it is likely to be so once again, perhaps even more so than ever, during any future bear market.
To this point, it is worthwhile to consider the following points about returns during the unwinding of the tech bubble. Yes, the S&P 500 Index fell by roughly -50% over the course of this three-year bear market from 2000 to 2003, but included over the duration of this bear market were four powerful and extended rallies in excess of +20%, plus another four rallies that were +8% or better. In short, active management opportunities even existed at the broader market level, despite the fact that the index was heading lower over time.
The same was true of the policy-sparked pre-crash period of what eventually came to be known as the financial crisis. Before the October 2008 crash, when the market had dropped by -27% to that point, the broader S&P 500 still posted five extended rallies of +8% to +15% along the way. And even the period once the crisis got underway had three major rallies of +18%, +27% and +9%, even during the five months of turmoil from October 2008 to March 2009. Once again, active management opportunities are there for the taking even under the most extreme market conditions.
Beyond active management, succeeding in any future stock bear market also involves emphasizing broad portfolio diversification. This includes the meaningful inclusion of asset class categories that stretch beyond the typically standard stock and bond (AGG) asset classes. For just because stocks may be in a bear market at some point in the future does not mean that other asset classes cannot be performing fantastically well at the same time. For example, long-term U.S. Treasuries (TLT) performed tremendously during both the unraveling of the tech bubble and the financial crisis. Same with gold (GLD), despite some bouts of greater volatility along the way.
The Bottom Line
Today’s stock market is not likely to end in a crash. Instead, any future decline is likely to be slower and take longer to play out, thanks to the continued interventions from global central bankers. Any future bear market unfolding in such a way would be most constructive for investors that are prepared to capitalize, as an abundance of upside return opportunities can continue to exist across capital markets even if the broader market S&P 500 Index is finding its way steadily lower over this same time period.
The key to success under this scenario is active management that includes a careful and rigorous security selection process, as well as an emphasis on broadly diversified portfolio allocation to provide upside opportunities while protecting against downside loss.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long TLT, PHYS, RSP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own selected individual stocks as part of a broadly diversified asset allocation strategy.