If There’s a Stock Market Crash Ahead, History Highlights the Best Strategy for Investors
I have bad news for anyone planning to buy stocks today: There’s a stock market crash coming in your future. Whether the crash starts tomorrow, in 10 years, or sometime in between, though, is anyone’s guess.
That said, there are a few reasons to expect it could be sooner rather than later. For one, stock valuations are stretched. The cyclically adjusted P/E ratio for the S&P 500 (^GSPC -0.22%) is near its all-time high, last seen at the height of the dot-com bubble. The Buffett indicator — the ratio of the U.S. stock market capitalization to its GDP — is at a record high as well.
On top of that, the index is heavily concentrated in big tech stocks related to AI, so a single crack in the AI story could send the entire market tumbling.
This isn’t the first time we’ve seen a market like this, and it won’t be the last. History tends to rhyme with itself. The smartest investors learn from history and apply the lessons to today, and that’s exactly what you should do if there’s another stock market crash ahead.
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The simple strategy that historically produces excellent results
Bear markets are nothing to be afraid of as a long-term investor. In fact, a market reset is often very healthy, allowing stocks to continue their march higher. It’s the exception that stocks head lower and stay lower for an extended period, as we saw in the 2000s or the 1930s.
A bear market is defined as a decline of 20% or more in a major index. The average S&P 500 bear market lasts less than 10 months from peak to trough. Some are gradual declines, others are more sudden, but either way, investors are looking at less than a year of pain in most cases.
That’s important to remember because the best strategy for long-term investors in the midst of a bear market requires the belief that future stock market returns will look relatively similar to past returns. An event that could completely displace U.S. stocks and keep pushing them lower for years on end is extremely unlikely, as both the central bank and federal government are working to support a stable economy.
The simple strategy to generate excellent returns in a bear market is to buy the dip. There have been 16 declines of 20% or more in the S&P 500 since 1940. The average 12-month forward return starting the day the index hits 20% below its all-time high is 17.3%. That’s well above the historic average return for the S&P 500 over the last 86 years. Any low-cost S&P 500 ETF, such as the Vanguard S&P 500 ETF (VOO -0.22%), is suitable for buying the dip in the index.
Today’s Change
(-0.22%) $-1.57
Current Price
$706.03
Key Data Points
AUM
$1.8T
Dividend Yield
1.04%
Expense Ratio
0.03%
Top Holdings
NVDA
8.09%
AAPL
7.04%
MSFT
5.70%
Of course, it’s scary to buy stocks in a market that’s already pushed prices down 20%. The index could drop even further. Indeed, it probably will, as 13 of those 16 bear markets saw drawdowns exceeding 25%, and nine saw maximum drawdowns exceeding 30%.
Here’s the good news: Those are opportunities to buy even more. The average one-year forward return after a 25% drawdown is 21%. If you bought after every 30% drawdown, the average return jumps to 22.8%.
Should you wait for a bear market?
The potential forward returns for patient investors appear extremely attractive. Considering the average one-year return in the S&P 500 is about 12.8%, waiting for an opportunity to invest at an average return of 17.3% or higher seems smart, especially if a bear market could be just around the corner.
But waiting on the sidelines for a market crash is a poor strategy. As famed investor Peter Lynch put it, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” The stock market can keep heading higher while cash on the sidelines won’t earn very much at all.
As such, the best strategy for bull-market investing is the same as that for bear-market investors: Keep buying stocks. The best investors will seek out stocks in companies they believe are undervalued, and they’re willing to hold for a long time, even if the market moves against them. But there’s nothing wrong with sticking to a simple index fund that’s historically produced phenomenal results over the long run.
