The past month hasn’t been positive for the FTSE 100 and S&P 500 indices. Both have fallen back from their 2021 highs (including the record high for the S&P 500). Today, the Footsie hovers around 6,970.24 points, down over 250 points (3.5%) since its 2021 high of 7,224.46 on 13 August. Likewise, the US index stands at 4,375.13 points, over 170 points (3.8%) below its all-time high of 4,545.85, reached on 2 September. After these recent pullbacks, some worry about the risk of a correction or even a stock market crash. But what’s the difference between the two? And what actually happens during market meltdowns?
Stock market crash or correction?
A correction is when share prices decline by 10% or more, but less than 20%. A decline of 17% is a correction; a loss of 7% is not. A stock market crash is when share prices decline by 20%+. With 101 days remaining of 2021, I could see a correction occurring this year, but probably not a crash. However, I could be wrong, as October is historically a brutal month for markets.
What happens during market meltdowns?
To show what happens during stock market crashes, I must explain what comes before. I’ve witnessed four market meltdowns in 35 years. These are October 1987, the dotcom crash of January 2000 to March 2003, the global financial crisis of June 2007 to March 2009, and 2020’s Covid-19 crash. I also know the history of the Great Crash of 1929.
Before crashes, stock prices generally climb in long bull (rising) markets. Ignoring the ‘flash crash’ of March 2020, the current bull market has lasted 12.5 years. That’s a long time for stocks to keep gaining. Furthermore, share prices frequently surge during the final stages of bull markets, often reaching record peaks. This is the euphoric phase, when momentum drives prices higher as more people (including newbies) rush to buy.
But bull markets have beginnings and ends. As Stein’s law tell us: “If something cannot go on forever, it will stop.” Stock market crashes generally start with modest daily declines, say, 2% here and 3% here. Then, as investors see the market reverse, they sell in ever-greater numbers. Here, the panic phase sets in as leveraged and over-exposed investors suffer ever-greater losses. Also, alarmed investors sell good companies as well as bad. Thus, the breadth of losses in market collapses can be extreme, hitting over-priced stocks and value shares alike.
When prices rebound
Finally, this brutal slide ends when investors realise that share prices are too low. This happened in March 2003, March 2009 and March 2020 (is there a pattern here?) Those who kept cash on the side-lines can now buy at bargain prices. Eventually, buying pressure sends share prices upwards again and investors feel relief at having survived another stock market crash.
One thing that’s tough to do is to time market cycles. Specifically, it’s almost impossible to sell at the top and buy at the bottom. Though I did this successfully since 2019. Roughly 21-22 months ago, as US stock prices hit new heights, we put 50% of our family portfolio into cash, banking bumper gains since mid-2016. But soon came ‘Meltdown Monday’ (23 March 2020), when US and UK markets crashed 36%. At this point, we reinvested our 50% cash, mostly in US stocks. And with the S&P 500 doubling from its 2020 low, we’re very pleased with this outcome. But today, I prefer to buy cheap UK value shares, mostly from the cheap FTSE 100!
