Market Crashes

I get asked quite often about whether the stock market is setting itself up for a "crash".   I've also recently seen more about this written in the financial press as more speculative parts of the market have come under pressure.  Here's what I think.

First of all markets have the potential to move lower at anytime.  Even in bull markets stocks will go through corrective phases.  This JP Morgan chart below shows that in almost every year, including those that showed nice gains, stocks at some point experienced a decline.  Take as an example 2012.  Stocks posted a 13% increase that year which is well above equities 8% long term annual rate of growth but they also at some point during that year went down 10%.  Last year's 30% increase versus only a 6% decline is more the exception.  The average decline most years per this chart is nearly 15%.

I’ll define for the purpose of this post a market crash as a brief violent period {a day to a few weeks perhaps} when stocks rapidly decline due to some outside unlooked for event. Simply put, crashes occur when sudden unexpected events catch the majority of investors leaning the wrong way.  That is investors  have too much exposure to the markets given the new level of risk that's suddenly been injected into the system.   The market’s decline after the events of September 11, 2001 is a good example of markets rapidly declining.  Another would be the market’s reaction in 2008 after the Government refused to bail out Lehman Brothers.  The first example is something that unlooked for washed over the gunnels.  It was an exogenous shock to the system that nobody could have foreseen.  Similarly,  if there's an earthquake tomorrow that leaves parts of Southern California  in ruins, then the market will likely experience a decline.  The discounting mechanism of the markets isn't currently accounting for something like this.  It is hard to protect your portfolio from such events since they cannot be predicted.  They may happen tomorrow or they may never occur.  The 2nd example happened because an outside entity {in this case the Federal Government} refused to act in a manner market participants expected which resulted in unlooked for shock to the system.

Investors may worry about something like the tensions over Ukraine as this sort of thing, but that crisis is so well known as to be on investor’s radar screen.  The market’s discounting mechanism is already working on it.  Currently markets don't see Ukraine as much of a big deal.  If they did then we'd likely have seen much larger declines.  The only way an event like Ukraine morphs into something more serious would be for events there to take a turn for the worse in ways markets don’t anticipate.  If for example we wake up in the morning and the Russian Army is marching toward Kiev then markets are going to have a bad day.  

I'm not saying we can't have a rough decline in prices at some point.  Investors should understand that stocks don't travel in a straight line higher.  Corrections are inevitable and are part of the market's mechanism that keeps financial excesses in check.  But a crash is in most cases an event that can't be gamed.  They are also rare.  In my opinion investors should spend more time concentrating on sound portfolio management than worrying about an event that may or may not happen.

*Long ETFs related to the S&P 500 in client and personal accounts.

Link:  JP Morgan Asset Management:  Guide to the Markets:  2Q, 2014