A Crash vs a Correction: Why Stock Markets Fall, And How You Can Take Advantage
Updated: Oct 27, 2021
Well what a week we've had. On Monday, the Dow Jones Industrial index shed over 2.6% in the worst single-day sell off since October 2020. The S&P 500 followed suit, dropping 2.7% and had its worst day since last November. The Nasdaq was hit the hardest, dropping 3.3% as tech stocks experienced a dramatic pull-back. American markets all simultaneously took a nose-dive as investors woke up to news that Chinese real estate developer China Evergrande Group is on "the brink of default." Wait...what? The share prices of American companies like Teladoc and Boeing fell multiple percentage points in a few hours because a Chinese real estate developer is about to declare bankruptcy? As weird as it is to say...yeah, pretty much.
Today, I' m going to cover what a stock market correction is, why it's not the crash everyone says it is and why they happen, as well as when. Then we'll take a look at the steps you can take to mitigate disaster. Unless you YOLO GameStop calls. Then you're on your own.
A Correction, Or A Crash? Gauging Levels of Fear
If you ask anyone off the street what happened Monday, they'd likely say that the stock market crashed, and your first instinct would likely be to agree with them. You switch on CNBC and see the "STOCK MARKET SELL-OFF" graphic flash across the screen before a New Yorker tells you why the sea of red you're seeing on the ticker at the bottom of the screen means that life, as we know it, is over. But let's take a step back. Investors, the crafty bunch that they are, have effectively created a different language when referring to a drop in stocks. Let's define some terms:
Dip - apart from being delicious with chips, a dip is a brief drop in the market, usually around 2%-5% and generally occurs over a few days
Correction - this is an aggressively specific drop in the market of more than 10%, but less than 20%, from their highs. Interestingly, there's no time-based definition for a correction, so it could last as long as it needs to prior to progressing up or down
Crash - this is a correction, but worse. A crash is a drop of greater than 20% from its highs, and generally occurs in a very short time frame
Bear Market - this is a market crash, but over a "long" period of time
Let's go back to that random person on the street. If you ask them how often the stock market crashes, their answer will probably be different depending on how old they are. If they're younger, they can probably point to the two most recent crashes: 2008 and 2020. A little older and they could point to the ".com" bubble of 2001 (RIP Pets.com). Older still and you'll get the crash of 1987. If you're really hunting and find someone in their extreme twilight years, they could point to 1929, probably the most famous crash that led to The Great Depression of the 1930's that concluded with the start of World War II. What I'm getting at here is that crashes happen, but they aren't overly frequent. Since 1929, there have been 13 stock market crashes, by the technical definition, equating to essentially one every seven years. But why?
Why Crashes Happen
Stock market crashes, as annoying as it is to say, can happen for any number of reasons. There is one main underlying condition under every single crash in stock market history, however: fear. Crashes happen when a massive pool of investors get spooked at the same time, resulting in mass selling. Then, thanks to supply and demand, the prices of shares, and therefore indexes, fall rapidly. But even though fear is present throughout, the factors that create that fear are very different. Let's run through a few:
The Stock Market Crash of 1929
For anyone that didn't grow up in an American public school, the 1920's in the United States are referred to as "The Roaring 20's." After the conclusion of World War One in 1919, America was in a state of economic and social boom (except Prohibition, which banned alcohol and created NASCAR. We can talk about that some other time). During the 1920's, life was good. Businesses were opening, wages were increasing, soldiers were home from war and manufacturing was booming. As a result, the market was accelerating upwards for pretty much the whole decade, increasing 10x in 9 years. However, no one bothered to take a step back and ask "why the fuck is this happening?" We now know that it was because of debt and excess. To simplify it, retail investors like you and me were borrowing massive amounts of money to invest in the market because it was accelerating so quickly. This was really the first bout of stock speculation, and it resulted in dramatic excesses of production and oversupply, eventually outstripping demand. In October of 1929, the music stopped. Markets dropped 11% in one day, bouncing upward briefly before capitulating to the tune of 89%. Investors got scared, pulling their cash and causing those that were over-levered to hold the bag. This caused issues with debt repayment, and banks took on heavy losses, with many closing their doors. This led to The Great Depression of the 1930's, and a very full chapter of U.S History textbooks.
The Crash of 1987
From 1982-1987, the Dow Jones Industrial Average in the U.S had tripled. But the 1980's globally had not been as kind. Constant back-and-forth between the U.S and the rest of the world had led to open hostilities, both in a literal and an economic sense. The U.S Federal Reserve had deals in place to depreciate the U.S dollar in order to get a hold of the ever-increasing trade deficit America had found itself in (sound familiar?). This was called "The Plaza Accord," and would be the pile of dynamite found at the end of the fuse for the stock market. The match? That would be the conflict in the Persian Gulf that left American investors concerned that we could shortly be at war. Finally, 1987 saw the widespread adoption of computer-based trading in order to execute stock transactions. Under normal circumstances, this system worked pretty well. However, the two events above led to mass selling and fear in investors, and the systems lagged. This caused more widespread panic, which accelerated selling, which accelerated the crash, resulting in a 22% drop in the market, the largest percentage drop to date. I wanted to cover this crash, though, because of the legacy it left behind. After this crash and the one in 1929, the adoption of computer-based systems allowed governing bodies to install "circuit breakers" which are still in use today.
These circuit breakers are safety-net systems installed in American exchanges that halt all trading for a set period of time if stocks decline by specific levels, with the idea that a breather and a water break will slow the momentum in volatility. A 7% drop halts all trading for 15 minutes. A 13% drop triggers another 15 minute break. If the drop continues to 20%, trading is halted for the rest of the trading day. These circuit breakers have been tripped five times since their implementation in 1987: once in 1997 and four times in March of 2020.
Other Notable Crashes
Since I didn't want this article to be a 45 minute slog of a history lesson, I'll quickly cover three other stock market crashes that have been more broadly covered:
2001 Dot-Com Bubble - With the internet still being in its nascent stages, companies that were web-based in their business model were still figuring out how to report metrics, and analysts were still figuring out how to value them. This caused wild misvaluations which, when coupled with the rampant venture capital funding in the market, led to overinflated share prices. When fundamentals caught up to valuations, prices crashed and investors were wiped out. Sound familiar...?
2008 Housing Market Crash - For a better illustration of what happened here, watch "The Big Short." Here's the quick version: American investors were taking adjustable-rate mortgages (ARM's) on their homes, purchasing homes they couldn't afford because banks were offering favorable rates temporarily that could fluctuate at a moment's notice. At the same time, those banks were packaging those loans and selling them to investment firms as mortgage-backed securities (MBS's), that were given high credit ratings due to meeting the technical definition of "diversified." These loans performed so well that, in an effort to make more money, these same banks took parts of those existing MBS's and combined them with other parts of MBS's (called "tranches") and packaged those into a new financial instrument: collateralized-debt-obligations (CDO's). Essentially, banks were betting on a bet on a bet. When rates increased and mortgage-holders failed to make payments, the entire system collapsed like a house of cards. That house had to be rebuilt on the back of a government stimulus to the very banks that made bad bets, crushing any sense of trust the American people had in the financial system and kicking millennials in the crotch along the way with brutal job prospects coming out of college from 2008-2012.
2020 Pandemic Crash - I don't feel like reliving this very recent hellscape of a situation. Just know that a global virus forced non-essential businesses to close, causing investors to pull out of the market, which cratered share prices. This is resulted in the circuit breakers mentioned above tripping four times in the same month. Then, like 2008, the government stepped in, issuing direct checks to citizens and loans to companies to keep them afloat. Combined with the Fed's quantitative easing program, this resulted in the shortest bear market in American history, lasting only four months.
How Can You Stay Calm In a Crash?
This little history lesson takes us to this week, where several factors led to Monday's sharp sell-off. The aforementioned Chinese real estate developer rattled the already frayed nerves of the American investor, who was already contending with COVID cases ticking back up, a weird curse on the month of September and a partisan dog-fight over taxes and the debt ceiling on Capitol Hill. All of these factors proved too great, and the markets dropped 2%-3.3%. Wait, that's it? Yep, that's it! Doesn't seem so bad now, right? Regardless, let's take a look at how you can prepare yourself and come out ahead the next time that the market goes subaquatic.
1. Don't Panic
Turns out, Douglass Adams knew what he was talking about. All of the above examples we ran through had fear as the undercurrent. So what's the best thing you can do in the face of adversity? Don't panic. You purchased your position because of a thesis you had in the company (hopefully). Do you believe in their leadership? Their business? Their dividend? Unless the fundamentals of the company have changed, stick with your original reason for purchasing. You can also take solace in the fact that the stock market has never returned a negative number on a rolling 20 year period. Ever. Never. Think about how mindbogglingly ridiculous that is. Stay invested kids.
2. Be Greedy
Warren Buffett is one of the greatest capital-allocators of all time. He's also a sound-bite machine who pumps out quotes like he pumps out stock-picks. One of my all-time favorites? "Be fearful when others are greedy, and greedy when others are fearful." Think about it like a store having a sale. If you bought jeans from that store two months ago, then they have a 20% off sale, you're not running back to the store to throw your old jeans at them, are you? No, you're buying more! Treat the market the same way. Those companies you've been watching are suddenly on sale. Take advantage!
3. Stay Balanced
This is why all of those "financial gurus" tout the same thing: diversification. Diversification will typically help mitigate the blow of a crash or correction, as your portfolio may get hit unevenly, reducing your downside risk. That's why many experts suggest you have bonds in your portfolio, as those are typically safe-havens during a sell-off, which is exactly what we saw Monday. International exposure can also assist in mitigating the eye-watering losses.
The Bottom Line
Just like with everything else in life, shit happens. The stock market is an unpredictable collection of people buying and selling companies because they think they're smarter than the person on the other side of the trade. Crashes, like Thanos, are inevitable. Stay calm, stay invested and stay balanced. This is how you win.
As an investor, how many crashes have you lived through? How many do you think you'll live through? Let me know in the comments below!