In retrospect, it’s easy to think of stock market crashes as abrupt shocks. And some of the most dramatic of them were actually abrupt. At the start of the Covid-19 pandemic, the S&P 500 index of American equities plunged 34% in just over a month. When Russia last defaulted on its debt in 1998, it took the index six weeks to go from peak to bottom, nearly taking Long-Term Capital Management and the rest of Wall Street with it. The quickest was the Blitz of October 19, 1987, or “Black Monday,” which wiped out 20% of the market in a single day.
However, the biggest downturns tended to be much more protracted. The stock market bloodbath that accompanied the 2007-09 financial crisis was not a single, dizzying slump: it dragged on for 17 months. Talk of the dot-com bubble “bursting” in the early 2000s may obscure the fact that it took two and a half years to get from peak to bottom. The biggest crash of all, which began in 1929, took nearly three years to run its course.
In any case, losing streaks were punctuated by weeks of rallies and choppy days when little happened. If not quite months of boredom punctuated by moments of terror, it was a long, uncertain drudgery. Today, six months after the US stock market began falling amid persistent inflation and tightening monetary policy, another slide may be imminent. But when the floor finally arrives, what will it look like?
Like a bubble, capitulation — investor jargon for the last, frenzied phase of a route — is accompanied by a kind of mania. It’s the part of the crash when something snaps into the collective consciousness and everyone who’s going to give up and sell does it. Perhaps it’s retail investors who have kept their nerve after losing a third of their capital but, faced with another 20% of value, decide it really could go to zero and rush to exit. Maybe they’re professionals who know it’s a bad time to sell but can’t faze their risk manager (or clients). In any case, it is the ferocity of the shakeout itself that creates the market bottom: those who refuse to sell at the height of the panic are unlikely to lose their composure later. After the frenzy is over, prices start to rise again.
So much for recognizing surrender in hindsight. Recognizing it as it happens is harder. Perhaps some clues can be gleaned from how historical crashes played out. Start with the roughest measurements: the length of the impact and the size of the drop from peak to valley. Excluding this year, the S&P 500 has had 14 bear markets since World War II — declines of more than 20% from a recent peak. The average downturn lasted just over 11 months and resulted in a drop of more than 32%. Both metrics suggest this year’s losses, which hit 23% in June before recovering somewhat, still have some time to go.
For a closer look, consider the March 2020 defeat. One lesson to be learned is that when the market crashes, trading volume increases. Towards the end of the crash, stocks in the S&P 500 were changing hands at more than double their average rate in the preceding weeks. The volume of UK FTSE 100 shares has tripled. Another signal is that a large proportion of the stocks in an index are falling in value. While the 2020 downturn was initially led by a handful of stocks, pretty much everything was flashing red in the final phase. True capitulation is achieved when contagion spreads not just from one stock to another, but across indices and asset classes.
Despite these measures, this year’s bear market has yet to peak. Investors are gloomy, but not so much that they’ve sold their favorite risky assets. Downside moves have started to include defensive stocks, but many of those in sectors like pharmaceuticals and telecoms are still ahead of the year. And the dips don’t sound like panic just yet: The S&P 500’s worst day this year was its 39th worst since the turn of the century. Trading volumes largely point to a market just trying to keep its cool.
If surrender is difficult to locate when it arrives, it is even more difficult to capitalize on it. How many prices have to fall in lockstep before it’s time to buy? Trading volume may have surged, but has it peaked? Are you sure you’ll keep your head when everyone around you loses theirs? Studying historical accidents is one thing. Putting your lessons into practice is quite another.
Read more from Buttonwood, our financial markets columnist:
How attractively are the stocks valued now? (July 25)
Is trading on the American stock exchange fair? (June 16)
Tech Investors Rethink Cash Generation (June 9)
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