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Is the Stock Market About to Crash

Is the stock market headed for a crash? Let's look into the facts to understand the likelihood, and what it means for your investment strategy.

Recent Market Performance

The Vanguard FTSE Global All Cap Index Fund is up 6% this year, after growing nearly 15% in 2023. This was a recovery from an 8% drop in 2022. Meanwhile, the S&P 500 has surged by almost 12% this year, reaching new all-time highs.

If you invested in these index funds over the past 18 months, you are probably feeling quite confident. But, if you are contemplating entering the market, or re-investing after the COVID downturn in 2020 or the correction in 2022, the current high valuations might make you hesitant.

Stock markets are at all-time highs, and equity prices are considered expensive by some. When prices are high relative to what they are perceived to be worth, it suggests investors may have paid too much because they are overly optimistic about future growth.

So, how likely is a stock market crash right now?

Understanding Market Crashes

Firstly, let's define a market crash. A 10% drop from a previous high is known as a correction. A 20% drop signifies a bear market, a crash is generally considered a 30% or more decline. While crashes are rare and typically short-lived, they do happen.

The S&P 500 data from 1871 (from Robert Schiller) shows total real return; inflation-adjusted and with dividends reinvested. The top part reveals how the market has grown continually over the decades but with many peaks and troughs. You can see immediately that the S&P 500 spends a lot of time pushing new all-time highs, but there are the inevitable pullbacks.

The bottom part shows the fall from previous all-time highs as a percentage, and over these 150 years, it shows six periods with the longest recovery times - from the day that the market falls from its previous all-time high to the point at which it recovers all-time high and then exceeds it.

The longest recovery periods have been during significant crises: the dot-com bubble and the global financial crisis took about 13 years to recover, with a fall of 52%. Similarly, high inflation and the energy crises in the 1970s also led to nearly 12 years of recovery time.

The two major global conflicts, World Wars I and II also caused substantial drawdowns.

Then we have arguably the worst fall in the US Stock Market during the Great Depression and that was another 7 year recovery time. This crisis marked a very deep peak-to-trough fall of over 70%.

But, before we get locked into a mindset of doom and gloom, remember that most of these falls are very short, which means that if you sell at the first sign of trouble, it's probably not going to work out well for you:

Time in the Market, not Timing the Market

The typical time the S&P spends below its all-time high before recovering is 61 days - just 2 months.

If you do sell when there is a little wobble, there is no way to know whether that little wobble will turn into a fully-fledged crash. Chances are it won’t and that means you will be locked out of markets – they snap back very quickly and you will be left thinking how do I get back into this market at a higher price?

So don't get discouraged by these long periods in the past when markets didn't recover. Be aware of them by all means - but they are rare.

The Probability of a Crash

Analyzing S&P 500 data from 1871 to 2023, the probability of a 30% market crash within a 12 month period is only 2%. A bear market 20% drop has a 6% probability, and a 10% correction has a 16% chance.

Over longer periods, the likelihood of a crash diminishes significantly.

For any 15 year period from 1871 to 2023, there is a 0% chance - the market has always ended higher than it started.

High Valuations and Market Highs

Currently, people are telling me they are scared to invest in equity because stock markets are riding high and equity valuations are also high. They fear this could cause a greater probability of a crash or at least a correction.

The stats do show that the probability of a crash is increased….from 2% to just 6%.

A bear market is more likely with a probability of 20%, and for a 10% correction, the probability is 39%, which is notable but not alarming.

Save or Invest?

Your time horizon is crucial in deciding whether to save or invest. If you need access to your money within a year or two, saving might be the safer option. Investing typically yields higher returns but comes with greater volatility. Historical data shows that for one-year investments in the S&P 500, there's a 73% chance of gaining money and a 27% chance of losing it:

There were 69 positive periods and 25 negative periods, so it's not quite a 50/50 toss of a coin, but it is definitely quite risky to suggest that you can invest for a year and make money. Also, don't forget that in any given year the stock market is going to have some crazy swings up and down inside that year.

These odds improve significantly with a longer investment period: a 3 year period has an 84% chance of gains, while a five or ten-year period shows even better prospects.

However, this is historical data and in this period, the 5 year numbers are not a whole lot better than the 3 year ones; this does show how luck plays a role in what you could end up getting back.

For example, if you wanted to save up for a house and had a big deposit ready, would you save or invest if you wanted to buy that house within the next 2 or 3 years? For short-term goals, high-interest savings accounts or a Lifetime ISA (LISA) might be more suitable.

I would definitely be saving into a LISA to the MAX!

Fear of Volatility

By understanding market trends, probabilities, and historical context, you can make informed decisions about investing versus saving. Despite the fear of crashes and corrections, the stock market has proven resilient over the long term, rewarding patient investors.

Investing works best when you have time on your side - ideally five years or more. For shorter periods, risks are higher, but saving or diversifying across different asset types can help mitigate potential losses.

Remember, investing is a long-term game. Stick to low-cost global index funds, avoid timing the market, Buy and Hold, and let compound interest work its magic. This will make you wealthy!


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