A stock market consists of publicly traded companies in multiple industries. These companies are representative of the health of an economy. As long as there is economic growth, the stock market will always recover and rise to new highs over the long term due to increased sales leading to higher earnings.
With that said, the stock market’s recovery is a somewhat complicated topic. In this post, I’ll dig deeper into why conversations about the stock market’s future become so complex, historical events we can learn from, and how investors should react while waiting for the stock market to recover.
Why a Straightforward Answer is Hard to Find
When you have questions about the market’s future, including if it recovers from previous highs, you may find it difficult to find straightforward answers. Every time we invest, we make a bet on an uncertain future.
And since we can’t predict the future, we must instead look at historical performance. And though past performance can’t guarantee future results, it can provide many valuable insights. So, what does history have to tell us?
History provides different information on the stock market’s recovery based on what the stock market is recovering from. The three main types of downturns you’ll hear about are corrections, crashes, and bear markets. But what’s the difference between these three types of decreases?
A stock market correction is a 10% decrease in value from the stock market’s 52-week high. In the United States, the S&P 500 is the yardstick by which we measure drawdowns. In a correction, the 10% decrease in value may happen over days, weeks, or even months. Corrections are a natural part of the roller coaster ride in the stock market and are often in response to a specific event, which leads investors to sell.
A correction is often part of a bull market – prices rise irrationally high, and a correction brings them back down to their reasonable or “correct” value.
While a correction happens over an extended period, a stock market crash is when there’s a 10% decline in a single day. If a crash occurs and stock prices drop another 10%, we’ve officially entered a bear market to a total reduction of 20%. Bear markets are big news because even though they don’t always result in a recession, they often do. While a bear market signifies that investors believe the economy will take a turn for the worse, it’s part of the market’s cycle. Between 1928 and 2019, the U.S. economy, as measured by the S&P 500, has had 25 bear markets and 26 bull markets. For each of those 25 bear markets, the stock market recovered every time.
As previously mentioned, it isn’t easy to talk about the stock market’s future. Instead, we look at historical performance to help us make educated guesses. One issue with this approach is that it can leave us unsettled, especially if there’s a stock market crash and the cause feels like something new and unprecedented.
While this is true to a certain extent, it also helps to keep in mind that the stock market is continually reacting to new events, trends, and circumstances.
When we look at the most significant market crashes, you’ll find them connected to everything from tulips to the internet. But there is a common thread among these crashes, and that’s a high level of speculation. In other words, when the market rises dramatically, a crash is almost inevitable as earnings and expectations come more in line with reality.
But no matter whether it’s a crash, correction, or bear market, the stock market has eventually recovered. Even when it comes to bear markets, a bull market has always returned and more than made up for the gains that were lost. On average, in the United States, stock prices have dropped by 36% during a bear market, but they have gained 112% during a bull market.
If we know that the stock market always recovers, the question becomes not if it will recover but when it will improve. And this is where things get tricky.
Recovering from a correction or crash is quicker than recovering from a bear market. In the United States, the average recovery from a stock market crash has taken four months. The average bear market has lasted about 14 months, with the subsequent recovery taking two years. It’s important to note that these are averages and consider the outliers. The time it takes for the stock market to recover varies depending on various factors, including current events, legislation, job growth, trade, etc.
The Nikkei, the Japanese version of the S&P 500, has been in a long-term bear market for over 30 years.
Reactions to Downturns
If you have money invested in the stock market, a correction or crash can be terrifying. Your capital is disappearing before your eyes. Many people’s first instinct is to pull their money out of the stock market until everything has settled down. While this response makes perfect sense on an emotional level, it’s often the exact wrong thing to do.
I think Warren Buffett said it best:
“I will tell you how to become rich. Be fearful when others are greedy and greedy when others are fearful”.Warren Buffett
Whenever there’s a crash, we often see charts showing the dip in performance within a relatively short time frame, maybe a year or two.
In this context, a crash looks catastrophic. That’s because the chart is tracking gains. Whatever the lowest the market has been in the time frame the chart is looking at is typically the baseline. Our minds think of this baseline as zero. This concept of zero is further enforced when we read headlines saying things like “stock market crash wipes out five years of gains.”
No investor wants to see their gains disappear, but it’s essential to remember that profits and value are not the same things. Let’s say you invest 10,000 in the stock market. Two years later, there’s a downturn in the market, and you lose everything you gained. Just like you did two years ago, you have 10,000. And while the goal of investing is to make money, there is no free lunch, and investors get paid because they take on risk.
Even accounting for corrections, crashes, and bear markets, you’re likely to see gains if you invest for the long term. Instead of thinking about stock market performance in terms of five years, consider a longer time horizon. To help with that, here’s the performance of the Dow Jones Industrial Average since 1900.
As you can see, if you invested in the stock market in 1990, when the year opened at 2,810, even with a 27% drop in value in 2020, you still end up with a year low of 18,591. This means you’ve increased your money more than six-fold or seen a gain of 562%.
But the only way to achieve this gain is to have your money in the market. Trying to pull your money out before a downturn and put it back in before an upswing is known as timing the market. As great as it sounds in theory, it isn’t possible for most professional investors, let alone retail investors. The most predictable aspect of the market is its unpredictability. When investors try to time the market or invest based on emotions, they often end up taking money out of the market when it’s low and putting it back in when it’s high. In other words, they’re buying high and selling low, which is the exact opposite of a sound investment strategy.
Whether it’s a correction, crash, or bear market, the stock market will eventually recover if the economy it represents recovers. While downturns often create fear, they are a natural part of the economic cycle. Most investors should be wary of trying to time the market as it’s difficult for most professionals to do it successfully. I’m not saying it’s impossible. Investing and trading for myself is how I make my living, but it took me years of intense study.