What Can We Learn From Previous Stock Market Crashes?

Includes: DIA, SPY
by: Gary Jakacky

Far more than any other word in the English language, the verb associated with the stock market is...crash! Fears of a waterfall decline probably keep more individuals out of the market than scandals could ever do.

This is unfortunate, because as you shall see, we have had numerous "crashes" since 1950. But the Standard & Poor's 500 index has grown from 17.29 to 1437 over this sixty two year span, a compounded growth rate of nearly 7.39% annually. Those outstanding returns, in spite of drops along the way, are now readily available to holders of broad based ETFs like the Standard & Poor's 500 ETF (NYSEARCA:SPY) or the Spyder Dow Jones Industrial Average, (NYSEARCA:DIA), at minimal cost. Diversification has never been simpler or cheaper.

Can we learn anything by studying these frightening events? Yes. Readers will find that

  • For most of the last 60 years, stock crashes were associated with events beyond strict financial purview: political or military crises, in many cases.
  • Since the late 1980s, however, strictly financial events have become the primary cause for these selloffs.
  • Both bear markets in the 21st century had crashes contained within them. Prior to this period, the crash either was the entire bear market or a separate event, from which shares quickly regained their postwar highs shortly after.

I confine my analysis in this article to the period after WWII, as this is when world economic, regulatory, and political events began to resemble the world as we (still) know it. I shall deal with 19th and early 20th century financial "panics" and crashes in a different article.

As an academic and researcher, the first thing that must be done is we need to define what we mean by "crash." A bit of digression. Unless a term in finance (in fact all research) is carefully defined, it cannot be properly measured and analyzed. Therefore, you can end up reaching any conclusion you want. That is exactly why such "research" is popular online: you can prove anything.

Consider the expression "stock market bubble." I have yet to read an article where this expression is carefully defined in advance and then used for analysis. Instead, people talk about "bubbles breaking" whenever their favorite asset - gold, oil, classic art, real estate - falls sharply in price. Thus it is impossible, going forward, to determine whether a bubble has formed or not. Yet this is what an investor must do in order to get tradeable information.

In this article I will define a stock market crash as a decline of 25% or more in a period of 3 months or less. This is what makes such crashes so frightening: their extent and swiftness. Gains that have accumulated over the last several years or more can suddenly vanish. And unlike the recent shenanigans at Talladega raceway, you cannot laugh it off as entertainment since it happens to the other guy; or change the channel and watch American Idol. Nope - you are right in the thick of it. At the worst time. Trying to decide what to do with your pup tent in the middle of the big storm.

What are these 8 crashes since 1950, and what were they associated with?

  • Late Summer 1957: prices fell sharply leading into the Soviet Union Sputnik launch that fall. Stock prices fell 25% in 3 months.
  • Spring 1962: Kennedy's clash with the steel companies set off fears of nationalization. Prices fell 28% in 3 months.
  • Summer 1970 and summer 1974: Both of these crashes had social, political and economic causes. The oil embargo, unrest on campus or in the nation's cities, tight money, and Nixon's resignation saw prices collapse 25% in 1970 and 35% in 1974. Both crashes were part of larger bear market moves.
  • Fall 1987: The granddaddy of market crashes for U.S. baby boomers, taking prices down 35% in just under two months, 22% on just one day. Almost exclusively due to computer program trading, impact on the economy was minimal.
  • The 1990s may be unique in the complete absence of a crash as I have defined it, though some jiggles in 1990 and 1998 rattled nerves.
  • BUT, as if the chickens had come home to roost, the first decade of the 21st century saw 3 market crashes, every one of which was part of a frightening bear market:
  1. Summer of 2002: though prices had been falling since techs broke more than a year before, the final wave took the S&P 500 down 29% in late spring 2002. The war in Iraq was the primary drag on shares that summer, on top of federal budget concerns.
  2. Summer of 2008: again, though prices began to fall late in 2007, a massive summer slide took prices down 43%. Bank failures, real estate tailspins and financial derivatives combined for the worst market since the depression.
  3. An often forgotten final leg took prices down another 29% in the first three months of 2009.

Market historians will notice that my strict definition of "crash" leaves a lot of selloffs on the table. But I wanted to concentrate on the worst scenarios.

Traders and investors can learn several lessons from all these crises.

First, political and military events that affect share prices tend to be very transitory and should not be cause for concern for investors. Buy quality and hold: you will get the last laugh. Market declines associated with the Korean War (outbreak of which caused a selloff but not a "crash" as I have defined it); the Cuban missile crisis (ditto), Kennedy's and Nixon's political swordsmanship, etc., were quickly regained. Traders should keep this in mind as we worry about Iran nuclear weapons, clashes with China, or European Union disintegration. The "crisis of the month" usually lasts just that long.

Second, crashes and panics have become part of cyclical bear markets in recent years, rather than stand alone events that catch your eye on long term charts. This has made cyclical bear markets far more cruel and frightening affairs in the last decade or so. Investors need to acknowledge this newfound volatility/exposure to the downside, adjusting their level of acceptable risk through diversification, cash/bondholdings, and dividend payments. Those nearing retirement need to understand that their nest egg can crumble 40% in a few months, and take a long time to recover.

Third, while crashes were bunched in the 2000s and absent in the 1990s, overall crashes are a regular part of stock price behavior, and not some kind of signal that something is inherently wrong with the trading system. Open outcry overwhelmed specialists in 1962; NasDaQ market makers refused to answer their phones in 1987; stop loss orders went off like fireworks in the flash crash of 2010. None of these events killed long term bullish trends. The exchanges provide the book: market history written in it is up to buyers and sellers like you and me.

Nor is anything wrong with the "political system" (no, it's not broken) or the "capitalist system." Democrats, Republicans, Conservatives, Liberals, times of balanced budgets and deep deficits have all been victims of market plunges.

Has the market become more volatile and dangerous in recent years? The first decade of this century sure seems to suggest it. Futhermore there is reason to believe this will endure: bull or bear, the stock market now has a ring through its nose pulled firmly by futures and derivatives markets. These are entirely different creatures than an equity market; far more volatile, so it should not be surprising to see increased noise in share prices. In my next article I will suggest ways investors can use options to lay off this added risk, even earning a regular cash return while they do so.

Disclosure: I am long SPY. 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 prefer to invest in broad based portfolios vis ETFs rather than individual stocks.