It's the three words investors most dread: stock market crash.
With the memory of the benchmark S&P 500's (^GSPC 0.56%) 34% nosedive in just 33 calendar days last year still fresh in many investors' minds, the last thing they'd probably like to think about right now is the prospect of another crash or steep correction on the horizon. Unfortunately, that's a very real possibility currently on the table.
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The case for a stock market crash is growing
Arguably the biggest concern for equities at the moment is valuation. Despite ideal conditions for growth stocks -- historically low lending rates, dovish monetary policy, and free-flowing stimulus spending from Washington -- valuations eventually always matter. As of this past Monday, April 12, the S&P 500's Shiller price-to-earnings (P/E) ratio topped 37, which is well over double its historic annual average of 16.81. The Shiller P/E ratio (also known as the cyclical-adjusted P/E ratio, or CAPE) is based on average inflation-adjusted earnings from the previous 10 years.
Why's this important? There have only been five instances over the past 150 years where the S&P 500's Shiller P/E ratio surpassed and held above the 30 level during a sustained bull market. In the previous four instances, not counting the current bull market event, the S&P 500 eventually retraced by a minimum of 20%.
There's additional historical precedence for moves lower following a bear-market bottom. Since 1960, the investment world has navigated its way through nine bear market declines, including the coronavirus crash. In each of the previous eight bear markets, there was an aggregate of 13 pullbacks ranging between 10% and 19.9% within three years of finding a bottom. To simplify this data, it means that every bounce-back from a bear-market bottom over the last 61 years has involved at least one or two knee-jerk moves lower.
Rising Treasury bond yields have been another recent concern. Although yields are still historically very low, their rapid rise in 2021 could throw a monkey wrench in the Federal Reserve's plan to keep lending rates at or near historic lows through at least 2023. It could also signal an uptick in inflation is on the horizon. Either way, rising Treasury yields have the potential to send borrowing rates higher, which could derail the very growth stocks that have led this rally.
In sum, there is no shortage of downside catalysts for the stock market right now.
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Knowing this will make you a better investor when the next crash strikes
Then again, a stock market correction or crash doesn't have to be perceived as a run-for-the-hills-type event. If you keep the following four metrics in mind, I can virtually guarantee you'll be a smarter investor when the next big down move occurs in the S&P 500.
1. Double-digit declines occur, on average, every 1.87 years
The first metric worth noting is that crashes and corrections happen a lot. Since the beginning of 1950, the S&P 500 has had 38 separate instances where it's drawn down by at least 10%, according to data from market analytics firm Yardeni Research. That's a double-digit decline, on average, every 1.87 years. For added context, it's been about 1.1 years since our last double-digit decline in the S&P 500.
To be fair, the stock market doesn't adhere to averages. We, as investors, like to pigeonhole equities into these averages to make ourselves feel more confident about what we're buying or selling. Nevertheless, this figure concretely tells us that crashes and corrections are a common part of investing in the market, and you could rightly say they are the price of admission to the greatest wealth creator on the planet.
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2. The average correction since 1950 has lasted 188 calendar days
One of the most important things to understand about market crashes and corrections is how long they last. Though we're never going to precisely know when a move lower will begin, exactly how long it'll last, or how steep the decline will be, history suggests that a majority of corrections don't last very long.
Data from Yardeni Research shows that 24 of the past 38 double-digit percentage declines in the S&P 500 found their bottom in 104 or fewer calendar days -- that's about 3.5 months. Another seven declines hit their trough between 157 and 288 calendar days (about five to 10 months). In other words, only seven times in the last 71 years has a double-digit market decline in the S&P 500 lasted longer than a year.
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3. Modern-day double-digit declines last an average of 155 calendar days
To build on the previous point, stock market declines have shortened even more in the past couple of decades. The advent of the internet has made access to information instantaneous and broken down barriers that once separated Wall Street and Main Street. This has minimized the effect of rumors on equities and, more importantly, helped to reduce the average length of crashes and corrections.
Since 1985 (an arbitrary year I've chosen due to the rise of computers on Wall Street), there have been 16 double-digit declines in the S&P 500. But given the faster transmission of information to professional and retail investors that we've witnessed over the past 36 years, the average crash or correction now only lasts 155 calendar days. That's 33 calendar days shorter than the 1950 to 2021 period when examined as a whole.
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4. Patience is a foolproof moneymaking strategy (38-for-38) during a crash
To review, corrections are a normal part of the investing cycle, they don't last very long, and they've been even shorter in the modern era. Now, for the best part: patience always pays.
Of the 38 aforementioned double-digit percentage declines in the S&P 500 since 1950, each and every one has eventually been completely erased by a bull-market rally. Similar to corrections, we'll never know ahead of time how long it'll take an index to get back to an all-time high. However, in many instances, it's taken a matter of weeks or months for the widely followed S&P 500 to reclaim new highs.
What's more, a report released by Crestmont Research found that at no point between 1919 and 2020 have rolling 20-year total returns (including dividends) for the S&P 500 ever been negative. In fact, the average annual total return over 20 years has only been lower than 5% for two of the 102 end years (1948 and 1949) between 1919 and 2020.
If you keep a level head during crashes and corrections and use that opportunity to pile into high-quality companies, you'll come out looking like a genius and feeling like a millionaire.
