The original version of this article was written back in 2021 in the wake of the COVID pandemic and the resulting crash in March of 2020. Since that time we’ve been through an inflation-driven crash in 2022, and at the time of this writing are experiencing a correction sparked by President Trump’s implementation of tariffs on trading partners around the globe. Given all that, I thought it would be a good time to revisit and update this look at past corrections, with the same goal of applying lessons from the past to current investment strategies.
Like Freddy Kruegers of the market, crashes haunt the dreams of investors, sowing fear and doubt. These periodic and painful hurricanes of lost money are jarring when they happen. However, investors should be aware that over time, fear of drops may cause more damage than the drops themselves. Crashes are relatively rare, but they cause an outsized impact in terms of investor behavior.
Because crashes play such an important role in shaping investor strategy and returns, we should study and learn from past examples. With that in mind, let’s look at the major negative market events of the past century. While there are notable similarities, each is unique, and we can learn as much from the differences as from what they have in common.
By way of loose definition, a correction is typically defined as a stock market drop of 10-20%, and they are quite common. On average we should expect corrections every 1-2 years. A crash is more dramatic, either in terms of magnitude – greater than 20% - or in terms happening very rapidly and dramatically (like the “flash crash” of 2010).
The Great Crash: Black Days
During the Roaring 20’s it became popular to believe that stocks only go up (we will revisit that doomed thought process – albeit with real estate - when we look at the 2008 meltdown). By Autumn of 1929 stocks had been on a nine-year run of fantastic returns. But cracks had begun to appear. In March the market sold off after comments by the Federal Reserve about excessive speculation… we will see echoes of that ahead of the early 2000’s Tech Wreck. In early September of ’29 a bearish economist named Babson warned of an impending crash, leading to a selloff that initially stabilized, but proved to be the start of a major collapse.
On October 24, 1929, what became known as “Black Thursday” - allusion to darkness would become standard in the language of crashes - the stock market plunged 11%. This was followed by the nearly 13% loss on “Black Monday’’ the 28th, and nearly 12% on “Black Tuesday” the 29th.
The Great Crash both presaged and added negative energy to the Great Depression that followed. Speculative mania and investor complacency – hallmarks of crashes to follow – were factors, but widespread economic sickness probably drove the magnitude of the drop. For purposes of this discussion we will define The Great Crash as part of a broad economic crisis.
70’s Inflation and Economic Malaise
Inflation is the silent killer of money. If a loaf of bread costs $1 on Monday, but $2 on Tuesday, you might still have $100 in your bank account but in bread terms you only have 50 bucks. That might not be as obvious as watching the value of your stock portfolio drop, but make no mistake, it’s a loss. A particularly insidious aspect of inflation is that its impact is ongoing and typically destroys a bit of value every single year.
We tend to think of crashes in terms of a sharp fall off a cliff, but the 70’s introduced a new form of market torture: the long slow ride to nowhere. The Dow Jones Industrial Average hit a peak in 1966 around 990, and then proceeded to trade more or less sideways before again hitting 990 in 1982. At that point it finally broke higher, entering into the greatest bull market America has ever seen.
Meanwhile, the dollar value of the market had eroded considerably during those years. Huge increases in the cost of oil and a related gas shortage were major factors. Additional issues such as high unemployment added to a sense of “economic malaise” (a description credited to President Jimmy Carter, although he didn’t actually use those words). Inflation hit a peak above 14% in 1980.
Maybe the market problems of the 1970’s were too slow and steady to use the term “crash”. So let’s just call it a period of prolonged financial distress rooted in monetary and energy supply problems.
The Crash of 87 – Boom!
The crash of ’87 is also known as “Black Monday”. A name that suggests a lack of originality among those who assign names to bad market events.
The Great Crash of the 1920’s played out over a period of several days (with the economic hangover lasting much longer). The sideways grind of the 1970’s stretched over more than a decade. In contrast, the crash of ‘87 hit like a fist on a single day.
On Monday October 19, 1987 the stock market plunged more than 20%. The causes of the intense ‘87 drop remain under debate, with one suspect being the rising influence of computerized trading. The idea that computers were to blame, which we will revisit when talking about the Flash Crash, is an example of common threads weaving through different eras of trading. One is reminded of the truism “history doesn’t repeat, but it rhymes”.
The 1987 crash can be categorized as an “out of the clear blue sky” event.
The Tech Wreck: Why the internet changed everything and was still a bad investment
Let’s step back in time to 1999. The top musicians included Whitney Houston, Britney Spears, and Ricky Martin. Google, Amazon and Netflix existed, but were largely unknown (if only we could actually go back in time!) Facebook and YouTube were yet to be born. The internet was a new concept. But we could sense that it would be big, that in some way it would change everything, so investors wanted in on the “.com” wave. We were right in a way, and if anything underestimated the enormity of the transformation that lay before us. But almost every technology investment made at that time soon became a complete disaster. Between 1999 and 2002 the tech-heavy NASDAQ index would lose a breathtaking 70%.
Think about that for a moment, and heed the lesson. The internet was about to change everything. But the internet, broadly speaking, turned into an abject disaster of an investment.
How could we have been so right, and yet so wrong? Because valuation matters, and profit matters. The net was poised to shape and reinvent almost every aspect of the economy, but adding “.com” to the end of a business name didn’t make it profitable. Some of the most successful companies in all of human existence – Google, Amazon, etc. – rose out of that era. But in far greater numbers businesses that could not navigate this brave new world ended in failure. No matter how fast an industry is growing, it can still be hard to build a company that will profit within that industry.
I see echoes of the .com era in the mini-mania over marijuana stocks a while back. Yes, the legalization of marijuana is a sea change, and a huge new industry is being born. But which companies will thrive, and which will fail? What are the barriers to entry in what is essentially a commodity business? Explosive growth does not guarantee success, you still need a good business plan. Moreover, for an investment to work out you need to buy in at a good price.
It's hard not to view the recent AI boom through the lens of the .com era, as valuations in that space have been very high. Although to be fair, many early players in the AI realm are hugely profitable businesses. Either way, it is the most interesting market sector of the moment.
We can define the Tech Wreck as a disaster based on inappropriate valuation.
2008 Global Financial Crisis
How did it all go so wrong? Did the government set the stage with regulations mandating lax lending standards? Yes. Did individuals lie on loan applications and make bad financial decisions to partake in the “free money” of the real estate bubble? Yes. Did rating agencies put their stamp of approval on garbage loan structures? Yes. Did the banking industry, broadly speaking, partake in an orgy of greed that destabilized the entire global financial system? Oh yeah they did. The underlying mindset was that residential real estate never falls much in value, which - like the idea from early last century that stocks never go down – was dangerously misguided.
It was one big money grab that almost ended in Great Depression II.
The 2008 crash resembles the Tech Wreck a bit in that it didn’t come entirely out of nowhere. The idea that real estate was in a bubble was discussed in the years leading up to the crisis. So the risk was, at least to some extent, known. It was the magnitude of the risk, amplified by leveraged structures created and sold by financial institutions, that caught the world by surprise.
Both the .com bust and the 2008 meltdown seem somewhat obvious in retrospect. How could we have missed the signs? Well, we could have missed them if we get warnings constantly and they are usually wrong. Greenspan’s now canonical phrase “irrational exuberance” – so spot on in retrospect – was poorly timed. He used it to describe market conditions in 1996. The tech wreck didn’t arrive until three years later, and in the intervening years the Nasdaq doubled. Proving that even if you are conceptually right, your timing can be way off.
The 2008 crash was born of a bubble in the real estate market, a bubble full of flammable gas in the form of complex financial products.
The Flash Crash
On the afternoon of May 6, 2010, starting at 2:32pm, the stock market behaved like an amusement park thrill ride. Minus the amusement. In the space of about 36 minutes, major US stock markets plunged 9% before recovering in similarly dramatic fashion. More shockingly, a number of America’s leading blue chip companies had their shares drop to a penny in value, while others soared above a thousand dollars.
While the impact of the Flash Crash was notably brief, it was frightening in that it represented a systemic breakdown. The underlying causes have been studied and to some extent debated, but it appears that large institutional trades triggered automated trading algorithms, leading to cascading moves in a number of stocks.
The Flash Crash was technological and structural in nature, pointing out the risk of a “ghost in the machine”. Consider it a more modern cousin to 1987.
The COVID Crash
The first public inklings of the COVID-19 pandemic began in January of 2020, but it wasn’t until March of that fateful year that the crisis exploded into the financial world.
In my mind the COVID crisis provides the starkest example ever of the disconnect between rational expectations, and market behavior. This can be illustrated with a thought experiment.
Imagine I am a genie and I approach you on New Year’s Day of 2020 with a crystal ball, and I show you what is about to happen. We see that a pandemic will sweep the world, and the streets of our cities will empty like a zombie apocalypse. Air travel will cease. Toilet paper and cleaning supplies will disappear from store shelves. Restaurants, the travel industry, and many other critical elements of our economy will come to a full screeching halt.
Amidst this insanity there will be racial and political strife at a level not seen since the 1970s. There will be riots across America which at times would prove deadly, and the Presidential election will be contested, culminating in a breach of the Capitol building and more loss of life. Meanwhile, murder rates will skyrocket in many large American cities.
Seeing all this in the crystal ball you would expect a market crash, wouldn’t you? You would expect 2020 to be a calamitous year for investors, maybe one of the worst ever. Well, stocks did plunge by over 30% in March. But by the end of 2020 the S&P 500 was up over 18%, the Bloomberg US Aggregate Bond Index was up about 7.5%, residential real estate appreciated notably, the NASDAQ gained an amazing 43%, and bitcoin tripled.
It was a year that will live in infamy, historically horrible, but it was a wonderful year to be invested. Remember that lesson well. Even if you know exactly what is going to happen in the world, and it is very bad, you still don't know what the market will do. You never, ever truly know what the market will do. Believing otherwise might be the most dangerous fallacy in the world of investing.
The COVID crash of March 2020 can be viewed as a natural disaster, but broader lessons about market unpredictability can be taken from the dramatic recovery that followed.
The Inflation Crash of 2022
In the wake of the pandemic and amidst supply chain issues, pent-up demand, and enormous amounts of stimulus spending, inflation reared its ugly head again in 2022. Until then we had been enjoying a stretch of relatively of mild inflation that dated back to the late 90’s. After the 2008 financial crisis we entered a period of extremely low inflation as the Federal Reserve found it could maintain growth-friendly low rates without incurring an inflation penalty. But beginning in 2021, as demand surged and supply chains remained disrupted, the consumer price index began hitting levels not seen in decades.
Conventional wisdom seems to be that we won’t likely see a return to ‘70s-stlye hyperinflation. But with consumers casting a wary eye at food and fuel prices again, echoes of past problems are called forth.
One big change highlighted by the current debate over tariffs is that the world is moving toward de-globalization. For decades we enjoyed very low inflation because manufacturing was largely shifted to China. That kept costs down due to a massive Chinese workforce that toiled for a pittance. From an inflation perspective it was a beautiful thing. But the pandemic highlighted the dangers of centralizing our manufacturing there. We found ourselves lacking for everything from toilet paper to medical supplies, because so little of what we need is made here. Moreover, the hollowing out of America’s manufacturing base had dire consequences for many of our workers, and for the communities they lived in.
The final nail in the coffin of “let’s just make everything in China” came from Chinese leadership, which has become increasingly bellicose in recent years, including an aggressive takeover of Hong Kong, and a more threatening stance toward Taiwan. We have to consider the risk of a future war with the supplier of most of our basic needs.
Our thesis is that going forward inflation will be “a thing” again. Setting aside the tariff issue which we’ll talk about next, the goal of moving supply chains away from China means that things are going to be more expensive. We expect inflation will ebb and flow in the years ahead much like it did for most of our economic history. Unfortunately, that means that some of our future crashes may be driven by rising prices.
There is a particular element of inflation-driven corrections that has relevance for investment strategy. For decades while inflation remained dormant, we could count on a dynamic that made moderate portfolios (a mix of 60% stocks and 40% bonds or thereabouts) reign supreme: when stocks fell bonds tended to rise. When risk caused stocks to fall – the tech market collapse in the early 2000’s or the global financial crisis of 2008 – money fled to the safety of bonds, raising prices in a way that partially offset stock losses. When the Federal Reserve rescued the economy in 2008 by dropping interest rates and flooding the system with liquidity in various ways, this dynamic was cemented in our national investment psyche. If a crisis came, the Fed would step in with low rates and bonds would benefit. The COVID crisis further codified this dynamic into “investment law”. Or so we thought.
Then along came inflation. The specter of rising prices is a negative for stocks and bonds. In 2022 as inflation spiked the S&P 500 lost about 19%, the Nasdaq lost 33%, and Bloomberg Aggregate Bond Index fell 13%. Lest you think there was nowhere to hide, many so-called “alternative investments” in areas like private equity and private credit posted positive returns. But that’s a story for another article.
The point we would like to make here is that inflation-driven crashes are different, and they have the potential to remove or reduce the role of bonds as safety nets. Just something to consider if we accept that inflation may be a part of our economic future much as it was a part of our economic past.
The 2022 crash was an inflation-driven event, and a stark reminder of the risk of rapidly rising prices.
The Tariff Tantrum
In addition to the movement of supply chains away from China – which we consider a given to some extent – another potential inflation factor going forward is tariffs. In this article I will set aside debate over the merits and drawbacks of tariffs, and focus on recent market turbulence related to their implementation.
In my 32+ years in the business I’ve never seen a close parallel to the correction that has unfolded during the past week, highlighting the tendency for market problems to be unique. Which makes sense if you think about it… if corrections all looked alike it would be easier to see them coming.
I write this from the weird perspective of knowing that by the time it is posted it will be stale information. But I take heart in the belief that it actually doesn’t matter, because the whole point of this article is to argue that sound investment principals remain steadfast through the ages, despite various disasters along the way. With that said, let me provide a quick summary of the wild ride the market experienced in recent days.
Donald Trump was elected last year on a platform that included protectionism in the form of tariffs. Voters knew this, and the market knew it and was apparently unfazed. On November 6 – the day after his win – the S&P 500 rose 2.53% and the Nasdaq rose 2.95%. Investors were heartened by the prospect of business-friendly policies, increased Government efficiency, and an extension of Trump’s 2017 tax cuts. From there the market trended higher until reaching an all-time high on February 19th. But at that point the market reversed into a mild a downward trend, as the uncertainty of Trump’s future moves came into focus.
The biggest source of concern involved trade policy. Trump is known for being mercurial when it comes to policy and communication, and this tendency has been on full display regarding tariffs. A hard stance on China was a given, but investors were surprised by the tough rhetoric - and high proposed tariff levels - when it came to Mexico, Canada, and other allies. Was he bluffing? Was it all just Trump being Trump, adopting a tough negotiating stance in order to attain favorable agreements with other nations? It was difficult to say, but there was a growing sense of unease due to the uncertainly, which was reflected in market volatility.
On Tuesday April 2 – which the President named “Liberation Day” – tariffs were announced that were far more aggressive than most were expecting. Rather than being reciprocal in terms of tariffs charged against us by other countries, the rates seemed to be based on disparities in the volume of trade. The rate for Vietnam, for example, was pegged at 46%.
On the Wednesday and Thursday that followed the marked plunged 10.5%, a two-day drop only exceeded in magnitude during the 2008 global financial crisis, the March 2020 pandemic crash, and the ’87 crash. The market continued to fall in the days that followed, only to experience a sharp rebound yesterday (April 9th) as Trump announced a “pause” to the enactment of tariffs. Unfortunately as I write this today, the market is falling hard again, although it hasn’t broken to new lows.
This crash is different from the others we discussed in part because it’s based on trade policies. But the truly unique aspect is that the market is bouncing around seemingly at the whim of one man. The implications of that are twofold in my view. It makes what happens next extremely difficult to predict. We can’t rely much on economic signals or past experiences for a sense of what is to come. On the other hand, at least for the moment it may be a very easy correction to “fix”. If President Trump removes a large measure of the uncertainty that is roiling markets, we could see an almost instant recovery. Although, if this market and business uncertainty continues much longer, the economic damage may prove harder to undue.
Thankfully, we rarely advise trying to manage a portfolio through a crash or correction. We believe in expecting bad economic and market stretches, and preparing in advance so you can wait out the bad time. More on that in a bit.
We will define the current correction as one driven by the ongoing development of Trump’s trade policies
False signals
I started this article with the suggestion that crashes may cause as much damage when they do not occur as when they do. That’s because of the way that fear of losing money influences investor behavior.
Studies by Morningstar and Dalbar have shown that mutual fund investors, on average, underperform the funds they invest in by somewhere between about half a percent and three percent per year. Since a good number of investors do follow a prudent “buy and hold” strategy and match the returns of the funds they are in, that suggests there are other investors who are badly underperforming over time.
Why the underperformance? Investors become fearful when the market drops and greedy when it goes up. In other words, they tend to sell low and buy high, the exact opposite of the approach that leads to successful investing.
We’ve discussed the biggest calamities in modern market history, and a few of the drops were dramatic. But those big drops are actually pretty rare, and in each case they were followed by recoveries. Some of the recoveries, such as in 2020, were fairly explosive in nature (highlighting the risk of participating in the downside but missing some or all of the ensuing upside).
It would be great if we had could recognize big crashes in advance and avoid them, but it is important to recognize that we do not have that ability. I think the biggest problem is that actual crashes are rare, but reasons to expect a crash are fairly common. Check out the chart below – courtesy of Ritholtz Wealth Management – that looks at the many causes for concern that popped up between 2009 and 2019. Note that in most cases the market just kept chugging higher (which, remember, is its default move).
Bad things, unfortunately, happen all the time. Wars, pandemics, economic meltdowns, political upheavals, you name it. And through it all the market, mostly, rises. That’s because it represents human beings striving in a free capitalist society. The upward trend in the US stock market is relentless because it reflects the business acumen, innovation, risk-taking and creativity of smart people from all over the world. Bad times will come, but as one of our market strategists recently put it: “companies are alive, and they will adapt”.
It makes sense to bet on that, and it makes sense to hold on through the tough times. There will always be more reasons to expect a crash than there will be crashes. And given the uptrend, if you decide to get out for a while because you think the market will go down, there is a better-than-average chance you will end up wrong and will be forced to buy back in later at a higher price. And what if you do that right before another leg down? Why drive yourself crazy trying to figure out how to navigate a correction when there is a much easier approach: wait for it to end.
We can’t say for certain that the uptrend will continue in the future, but the stock market has a long and impressive record of proving pessimists wrong.
The Armageddon Scenario
I’m sometimes asked to play the “what if” game about scenarios that could truly destroy the economy and the market. What if we have a nuclear war with China, what if the next pandemic wipes out half the Earth’s population, what if an asteroid or volcano causes a near-extinction event?
You can’t make sound investment decisions based on a potential apocalypse. First of all, in the absence of an apocalypse your investment results will be terrible. Moreover, in the event of an actual alien invasion, cyber meltdown, or otherwise completely out-of-control situation, your money probably won’t do you much good anyway. You’ll be needing canned food, firewood, guns and ammo, and ideally some farmland in a remote location on an easily-defended ridgeline.
I’m not advising against preparing for serious emergencies. I’m just saying that investing based on the assumption of horribly dire outcomes is a low-probability approach.
Set It and Forget It
If you look at the good (uptrend) and the bad (crashes) of market history and decide you want money in stocks, learn from the past and make smart decisions. Our examination of crashes reveals they are hard to predict because they are rare, because false signals are abundant, and because they all look and feel a bit different which makes them hard to see coming. The most educated and experienced investors in the world have shown scant ability to consistently predict the market’s next move. So do not beat yourself up in a doomed effort to do so.
Decide how much money you are willing to have at risk (either with the assistance of a financial planner or on your own) and buy a diversified portfolio of good companies. Pair that with holdings in less volatile asset classes like bonds and cash, and perhaps additional categories such as real estate, private equity, commodities and currencies. Then hold on for the ride. When the next crisis comes along and asset values plunge – which will happen – consider one of these two time-proven strategic reactions: sit still or buy more. It is not impossible to execute a more tactical approach that involves cutting risk during downturns, but it every difficult to pull off, and the effort more often than not leads to poor results. Doing nothing has a much stronger track record of success.
We cannot guarantee that what has worked in the past will work in the future, but successful investing requires taking and managing risk. One of the most common risks is bad decision-making, including the natural tendency to get in and out of the market at the wrong time. It is well within your power to eliminate that risk.
The two best attributes an investor can have are humility and patience. Humility to recognize that you have no ability to predict the market. Patience to get you through the rough spots. Exercise those traits and you can take advantage of the incredible wealth-creating power of the American (and global) economy and stock market.