Financial crises are times of high uncertainty that can cause stress and questioning for any investor. What will be its depth and duration? Will the market rebound? Should I liquidate my portfolio? Looking at the history of financial markets and analyzing past crises can tell us a lot about the behavior of crises and help us adopt the right attitude when the time comes.
The market rises and falls continuously so that every other trading day ends with a negative performance. Declines are therefore the daily reality of investors. While most crises are quickly forgotten, some last longer and are remembered. We speak of a market “correction” when the market drops more than 10% from a peak. If a correction continues and exceeds a 20% drop, we will speak of a stock market crisis, “Krach” or bear market. Most seizures are limited to a decrease of 20-30% but some are temporarily more severe.
Crises share common characteristics so that they can be categorized. Many stem from the burst of speculative bubbles, such as technology, banking or Chinese stocks. Others are linked to excessive debt, often originating from real estate speculation. Finally, some result from factors exogenous to the stock markets such as wars, oil shocks or pandemics. Despite some common roots, each crisis is unique and therefore difficult to anticipate, even for professional investors.
Crises are usually preceded by periods of strong economic and stock market boom, even euphoria, that do not let anything foreshadow. On average, crises are preceded by a 9% increase in the market over the preceding 3 months and a 26% increase over one year. This is 3 times the expected average annual return of stock markets. In view of these good performances, trying to anticipate the decline by liquidating a portfolio often proves to be a perilous and costly exercise for those who try; the opportunity cost of not being exposed to the market during these periods being very high.
Most stock market crises occur in parallel with an economic recession, that is, a period of economic decline of more than 6 months. In all cases, the market decline precedes the onset of the recession just as the market rebound precedes the economic recovery. So, the market is always one step ahead of the real economy. It means that trying to anticipate a stock market crisis based on economic indicators is completely futile.
Our financial memory is selective and tends to only remember major crises, such as the 2008 financial crisis. Many investors therefore consider financial crises to be infrequent events. Yet over the past 50 years, the global equity market has experienced 12 stock market crises - one crisis every 4 years. In this volatile environment, it is therefore preferable to put up with this kind of event that you will face many times in you investor lifetime.
A stock market crisis takes on average 1 year to reach the lowest point before rebounding; the longest crisis having lasted 2 and a half years following the bursting of the internet bubble in the early 2000s. However, this average duration is not representative of most crises which have a lifespan of less than 6 month. As painful as they are, crisis tend to pass relatively quickly. Their duration being very variable, it is always risky to jump off the train hoping to get back in lower.
In the midst of the stock market storm, the tide turns quickly and all it takes is a spark for the market to reverse course. The rebound is generally very vigorous and catches by surprise most investors who simply remained focused on the stressful context of the crisis. The average gain during the first week after a rebound is 6%. After a month the gain rises to 18%, and it finally reaches 37% after a year. The period of increase following a stock market crisis is also on average 3 times longer and delivers an average increase of 105%. Patience and tenacity therefore always reward the long-term investor.
In summary, stock market crises are:
In this context, the best attitude to adopt is to keep calm, to be patient, to focus on the long-term objective and possibly take the opportunity to rebalance the portfolio or invest more.
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.