This has been a "buckle up and hold on" type of year for investors. The unprecedented coronavirus disease 2019 (COVID-19) pandemic created a level of panic and uncertainty that Wall Street had never contended with before. Ultimately, the broad-based S&P 500 (^GSPC -0.05%) lost a whopping 34% of its value in just 33 calendar days. For context, it's historically taken the S&P 500 an average of 11 months to shed 30% of its value during bear markets.
However, Wall Street and investors have also witnessed the strongest rebound from a bear market bottom in history. Following the S&P 500's March 23 low, it took it less than five months to reclaim a fresh all-time high.
But just because Wall Street has seemingly shrugged off the wildest bear market ride in history doesn't mean equities are out of the woods. A trio of big down days between Sept. 3 and Sept. 8 served to remind investors that volatility hasn't gone anywhere, and neither has the coronavirus.
The question is, could this recent volatility signal that stock market crash 2.0 is imminent?
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History shows that stock market crashes are an inevitable part of the investing cycle
The only correct answer to this question is that we just don't know. It's impossible to predict very short-term movements in the stock market with any accuracy. Additionally, we'll never know ahead of time when a crash or correction will occur, how long one will last, how steep the drop will be, and what caused it.
But even though we can't concretely say that a crash is imminent, we can say with a certain degree of confidence that a crash or correction following the ferocious rally we've witnessed since March 23 is inevitable.
You see, there have been eight official bear market declines -- official in the sense that the drop was at least 20% from a recent high, without rounding -- over the past 60 years. In the subsequent three years following the bottom for each of these eight bear markets, there were an aggregate of 13 stock market crashes or corrections ranging between 10% and 19.9%. To put this data another way, the typical bear market rebound will see one or two substantive corrections or crashes within a three-year period. It should be noted that, in many instances, these declines occurred much sooner than the three-year mark.
Additionally, the S&P 500 has undergone 38 corrections of at least 10% (again, unrounded) since the beginning of 1950. This works out to a double-digit percentage correction, on average, about every 1.8 years. Significant declines in the stock market are simply an inevitable part of the investing cycle.
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These catalysts add fuel to the fire that a crash may be coming
Keep in mind that it's not just historical data that backs up the idea that stock market crash 2.0 is inevitable. There are no shortage of catalysts fanning the flames of fear on Wall Street.
For one, COVID-19 still offers plenty of unpredictability. It's unclear how the country will fare heading into flu season, and there are absolutely no certainties when it comes to vaccine development. Though we've witnessed a couple of promising vaccines move into later-stage trials, efficacy and the willingness of the public to get a vaccine remain total unknowns. If vaccine efficacy isn't outstanding from these late-stage candidates, future lockdowns may await.
Election uncertainty could also unseat this amazing rebound in equities. At this point, Wall Street expects Democratic Party challenger Joe Biden to unseat incumbent Republican Donald Trump. Even though that might mean higher corporate tax rates, Wall Street favors certainty. If, however, the polls begin tightening in the remaining weeks, we could see very pronounced volatility.
We're also more than a month-and-a-half beyond the point when enhanced unemployment benefits ended. While we've seen the employment picture improve on a regular basis since April, an unemployment rate of more than 8% is far from ideal. With Congress unable to pass another round of stimulus, it's not out of the question that mortgage, loan, and credit delinquencies will begin to soar dramatically in the final months of 2020. That could prove devastating to our nation's financial sector.
Finally, don't overlook that the Federal Reserve entered this downturn with one hand tied behind its back. The nation's central bank has historically reduced its federal funds rate by 500 basis points to induce an economic recovery. But the Fed's starting point this time around only allowed it to reduce the federal funds rate by half that amount. Monetary policy and quantitative easing measures can only carry the economy so far.
All of these factors would support the idea of stock market crash 2.0 being inevitable and possibly imminent.
Image source: Getty Images.
Three things to do when the next stock market crash occurs
What you're probably wondering is what should be done if and when stock market crash 2.0 rears its head. The answer is threefold.
First of all, relax. As I noted above, corrections and crashes are a natural part of the investing cycle and part of the price of admission to the greatest wealth creator on the planet. Historically, bull markets and periods of economic expansion last far longer than recessions and corrections. As long as you're maintaining a long-term mindset, there's nothing to be concerned about.
Second, a stock market crash is a good time to reassess your holdings (although you don't need to wait for a crash to do so). By reassess, I mean analyze your portfolio to see if your original investment theses still hold water. If the reason(s) you bought a stake in a company are still valid, then there's no need to panic if emotional investing whipsaws your holdings for a couple of weeks. If, however, your investment thesis is broken, it could be time to consider selling.
Third and finally, get the proverbial shopping cart out and start purchasing. The stock market has averaged a 7% return, inclusive of dividend reinvestment, over the long run -- and that includes all those corrections I alluded to earlier. Major stock market indexes, like the S&P 500, have a propensity to rise over time as operating earnings for their underlying components expand. This suggests that if you buy stakes in high-quality and innovative businesses and give your investment thesis ample time to play out, you should be able to build substantial wealth during crashes.
