What to Watch for in the Stock Market Crash and How to Invest
The sky is falling and instead of one solitary chicken little screaming the warning, it’s a million investors as they live through the frustration and despair of a stock market crash.
I’ve been investing for 23 years now, with more than a decade of that as a professional analyst and in private wealth management. I can still remember my first stock market crash in 2000, just after starting in investing and the daily pain endured from watching stocks fall lower.
One thing I’ve learned over that and other market crashes since, is that there are common signs you can look for to know when stocks might stop falling and that right now could be the best time to invest.
In this post, we’ll look at the definition of a stock market crash and the common stages investors go through in the stock market cycle. We’ll look at a history of bull and bear markets to understand when stocks might stop falling and I’ll show you exactly how to invest right now.
What is a Stock Market Crash?
The technical definition of a bear market is when the broader market index, usually the S&P 500, falls 20% from its recent peak in prices. This is the market definition but you can also have a bear market in individual stocks or other groups, when they’ve fallen the 20% from the highs.
We use the term ‘market crash’ because that’s how it feels. After years of stocks that seem to go nowhere but higher, prices fall suddenly and shock investors into reality. The quickness of a stock crash is the hardest part because, like a car crash, it’s so fast that no investor has time to get out of the way.
In fact, we’ll look at a history of bear markets later that shows the entire stock crash averages just nine months and falls 28% from the peak. That’s a third of your money wiped out in less than a year.
Stock Market Cycles
Anyone experiencing a stock market crash can tell you, the technical definition doesn’t tell the whole story. Stock crashes are as much a feeling and experience as it is how much the market falls.
The stock market runs in cycles, typically tied to the business cycle of profits and a recession every three- to five-years. In every boom and bust cycle, every single one was marked by common investor moods.
The graphic highlights some of the most common investor sentiments through the bull and bear market. Much of successful investing is being able to see the herd mentality for what it is and being able to keep a calmer head. Whether we’re in a bull or bear market when you read this, keep the graph handy and see if you can spot the investor reasoning for the current period in the graph.
As stocks begin to recover from the bear market, investors still doubt the new bull market because they’ve lost too much money. It’s here were remembering that stock market cycles happen and that after a long bear market is the best time to invest before prices start rising again.
As stock prices continue higher, investor optimism builds as more people start to believe the market has turned. That optimism turns to fear of missing out (FOMO) and pulls everyone back into the market. It’s usually at this point that the investors who gave up and sold all their stocks at the bottom of the stock crash finally get back into the market, missing out on much of the new gains.
As the economy starts to overheat and inflation runs higher, policy makers start pulling back on economic stimulus. This spooks the market into a selloff but investors are so used to seeing stocks go up they barely notice. Even as the market falls, investors reason that stocks have rebounded from every dip over the last several years and they should now as well.
Denial turns to bargaining as investors realize much of their bull market returns have been wiped out. They push more money into stocks or even start investing on margin on the hope…the prayer, that stocks will rebound just enough that they can break even.
Finally, losses get so bad that investors give up. This happens in a mass capitulation event where a big single day loss scares remaining investors into selling. Stock prices may stay low for a while after but this is generally close to the bottom. With so many investors scared out of the market, there are fewer sellers and only long-term investors left. That means any good news that brings in investors will help boost stocks into a new bull market.
How Bad is the 2022 Stock Market Crash Compared to History?
Investing through a stock crash can be more than frustrating, it will test your soul. You see the bad news daily and more of your friends give up, selling out in desperation. Here it can be helpful to look back on history and the average stock return for a sense of perspective and calm.
Investors can take comfort in the fact that bear markets have always given way to higher stock prices eventually.
The average bear market has lasted just nine months in 12 cycles back to 1956. The average fall has been 28% from the peak in prices. This average may be a little misleading as some of the bear markets were not followed by recessions while others saw a drop in economic activity. Those bear markets followed by a recession tended to be slightly longer and deeper, averaging about 35% from the peak.
Still though, looking at the graph and it becomes immediately clear that stock crashes are brief and infrequent. The market spends much more time rising in a bull market than it spends falling and prices boom higher by much more than they fall. The average bull market is six-times longer than the bear and rises nearly 130% from the low in prices.
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Why is the Stock Market Crashing?
There are common reasons stock prices fall into a bear market and while no two bear markets are alike, Mark Twain was right in that history does rhyme rather than repeat.
The easiest way to explain why stocks are crashing is simply to look at why stocks boomed higher in the preceding years. The factors that led to the boom more often than not are the ones leading to a bust.
This time around it was the immense amount of money pushed into the economy during the pandemic. Upwards of $15 trillion globally and more than $8 trillion in the United States alone was pumped into the economy through stimulus and bond-buying programs. We certainly needed something to keep from falling into a depression but the fact that consumer spending dropped to nothing in the lockdowns meant that money had nowhere to go but into stocks.
As people poured their stimulus checks into the stock market, stock prices soared. As those prices soared, investors feared they would miss out on further gains if they weren’t fully invested. More money chased stocks and investors even started to borrow money to invest.
The Federal Reserve is now pulling back on the two levers it uses to boost the economy. It’s increasing interest rates, up from zero at the beginning of the year, and not buying treasury or mortgage bonds. The federal government is also slowing the economy by not spending as much as it did during the pandemic.
The Fed is expected to continue raising rates and shrinking its bond portfolio well into next year, which means it could be a longer bear market. The question then is, how should you invest?
How to Invest in a Stock Market Crash
I’ve found that three rules for investing through a stock market crash will not only lower the stress and frustration of a bear market but also make you more money in the long-run.
First is to understand that a market crash may be the best time to invest. People love pushing money into stocks as prices are booming higher, but then get scared and stop investing as prices come down. With stocks down so far from their peak, this is the only time you know you’re getting a good deal as a long-term investor. Stocks always return to their past highs so you know buying now will mean returns in the future.
It also helps to make a plan for investing, especially for investing any cash you’ve saved up outside of stocks. Too many investors stress out watching stocks fall every day, wondering if this is the market bottom and now is the time to invest. They end up freaking out and pushing all their money into stocks too early, only to watch the market continue to fall.
Instead, make a written plan for when you will invest chunks of your cash. This means taking an index like the S&P 500 and setting milestones where you will invest. If the market is at 4,000 currently then you might plan to invest a third of your money at 3,500 followed by another third at 3,000 and the rest at 2,500 on the S&P 500. This kind of planning will allow you to put money to work and benefit if stocks do recover but will also hold some back to invest later if stocks continue to fall.
More importantly though, making a formal plan and sticking to it means you don’t have to stress over the market on a daily basis. You know exactly when you’re going to invest and don’t have to worry about timing.
Finally, focus on ways of making more money to invest. We know that bear markets don’t last and these lower prices are the best time to invest. If you haven’t saved up some cash to invest then the next best thing is finding ways to make more money. That doesn’t mean taking on a second job but even a part-time side hustle for a few months can give you a few thousand to invest and grow your portfolio.
The stock market crash does not have to be a time of frustration and despair for investors. Looking to history for the perspective that stock crashes turn into bull markets and realizing this is one of your best opportunities for long-term returns can help brighten your outlook on investing.
Don’t Miss the Rest of the Stock Market Crash Series