Market Crashes When This Happens 📉
Human behavior signals market crashes much more accurately than statistics.
Market is going to crash.
This is not a prophecy, this is not a prediction, this is a reality.
Every now and then, the market experiences a drawback. On average, we get a 5% correction in every 4 months, 10% every year and 15% every 3.5 years.
Once the correction reaches over 20%, we officially call it a “crash.”
Crashes tend to happen once in every 6.3 years.
Crashes are the worst nightmare of investors.
When you think 20% just as a number, it may not look too big for you and you may think that you can take 20% loss in your portfolio.
It doesn’t happen that way…
When the correction reaches 20%, the only things that keep the market alive are the absolute strongest businesses that investors believe have no chance of failure.
These are the businesses like Coca-Cola, American Express, Visa, Mastercard, JP. Morgan Chase, UnitedHealth… The businesses selling products that people won’t stop spending money on until they literally have no money.
All other businesses experience way harsher drawbacks.
Even the ones like Apple.
During the 2008-2009 market crash, Apple stock plunged from $28 to $12 levels, a 58% crash.
It wasn’t because people thought Apple was a bad business, it was because investors thought everything was so bad that people wouldn’t spend money on Apple products.
Apple at the time was the most innovative company in the world that had just launched the iPhone.
What do you think a crash that can pull Apple down 58% could do to smaller businesses?
They get obliterated.
Result? For most people, 20% market crash feels more like 80% and many people lose everything.
This is why predicting a market crash and avoiding it is of utmost importance and people look at many metrics and indicators to predict them like historic P/E ratios, Buffett indicators, market concentration etc…
Let me be straightforward here: They don’t work.
⛔The Problem With The Crash Indicators
They don’t work because they are backward looking.
We look at the past and we try to see what was abnormal that could have heralded the crash.
Take a look at the PE ratios for instance:
Historical average PE ratio for SP 500 is 18.
In the Great Depression, it went above 30; in the Dotcom Crash, it went above 40.
You could have looked at this picture and assumed that the market is likely to crash when the average PE goes above 30.
Yet, this would have led you to miss the 2008 crash.
This problem exists for all other standalone indicators. Even if you use several indicators together to make better assumptions, you won’t likely get the next crash right.
How do I know that? Because many people have already tried all those things.
There are too many smart people in the market trying to predict the next crash. They look at standalone indicators, they consider many indicators together and yet we don’t have a dependable way to predict market crashes.
The reason is simple. Mark Twain explained it a century ago:
Similar dynamics tend to lead to similar consequences but they don’t happen in the same way.
Similar conditions lead to formation of similar bubbles in the market and then they burst similarly.
This gives us a crucial insight: Instead of focusing on numbers, focus on the conditions that lead to formation of bubbles and be careful when you see them.
🧐What To Look For Instead?
Too many people are too focused on numbers that we don’t try seeing the problem itself while it’s also visible.
It’s like looking at the statistics of the rainy days in your city to see whether you are going to get a rainy day while you could easily look out of the window and see if the clouds are forming.
We should look at the problem itself instead of the data that could signal the problem.
What’s the problem here?
It’s not a numbers problem. It’s a human problem.
Bubbles aren’t formed by the numbers on paper, they are formed by people taking things to extremes.
When everything is good, most people believe tomorrow will be good too and some of them bet on this.
When they bet on a better tomorrow, the odds of a better tomorrow increases.
When the better tomorrow comes, more people become optimistic and bet on a better tomorrow.
This creates a self-sustaining cycle until one of the two things happen:
Tomorrows start not being as good as predicted.
People predict tomorrow will be much better than it’ll actually be.
In both cases, a disconnect happens between the reality and expectation.
In the first case, the cycle goes on until somebody screams that the king has no clothes.
Then others look at it and they see it too. When this happens, people race to exit the market before others, knowing that those who exit early will minimize losses.
Here, we get a market crash.
In the latter case, the future really turns out to be better, but it’s much less better than the expectations that people think it’s actually bad.
Same race to exit the market begins again.
Again, we get a market crash.
So, the critical question is when people start to take things to their extreme?
How do we understand when people start to believe that the future will be much better than it actually will be?
Bubbles start forming when people start acting against their nature.
What does this mean?
Well, people are actually risk averse, not risk seeking.
Daniel Kahneman and Amos Tversky pioneered the concept of loss aversion.
They found out that people feel much stronger pain for losing $5 then the happiness they feel for winning $5.
Thus, we are biologically wired to avoid losses rather than maximizing gains.
Naturally, when presented with an investment opportunity, the first thing people ask is “what’s the downside?” not “what’s the upside?”
I do that too.
I analyze hundreds of stocks every year and the first question I ask is what’s the downside?
I try to avoid everything that exposes me to the risk of permanent loss of capital. It doesn’t matter if the upside is 10% or 10x.
Most people are the same. Just try it, go pitch them a stock and they’ll get back to you with risks rather than the opportunities and they’ll ask you to address the risks.
📉 Market crashes when this changes.
When we start looking at the potential upside before the potential downside, we start getting things to their extreme.
Here is how it happens:
In good times, real opportunities in the market get oversubscribed so people start looking at mediocre opportunities.
They buy some mediocre stocks that have higher risk but they go up too because other people who missed the real good opportunities do the same. This doesn’t happen overnight, it spreads over time.
Months and months pass, people look at their brokerage accounts and they see they made huge amounts of money on mediocre stocks.
What happens then? They get convinced these mediocre opportunities were actually good opportunities.
They instantly start looking for other opportunities like them and ask for the upside first instead of the downside. This happens because of two reasons:
1) Things have been going so well for so long that we genuinely forget the downside.
2) Money we made makes us think we can absorb higher risks.
And this happens systemwide.
It’s not just investors who think they can take more risk.
Loan officers in the banks also think that they can ease the lending conditions a bit, executives in the firms also think they can invest in projects that will 90% fail but generate 5x returns if they succeed, venture capitalists start investing on pitch-decks rather than prototypes etc…
It spreads in the system like a virus…
Suddenly, you are investing in stocks that you wouldn’t have invested in a year ago, loan officers are approving credits they wouldn’t approve in bad times, venture capitalists are funding ideas instead of projects…
When a domino falls, when a bad loan is not repaid, when a mediocre stock misses sky-high earnings expectations, it sends waves of awareness.
People look at their portfolios to see whether they are holding such bad businesses, banks look at their potentially bad loans etc..
And what do you think they see? They see a bunch of bad apples.
They start throwing them out of the basket as fast as possible. This is how the market crashes.
How did it start? It started when people started asking the upside before the downside.
🤔How To Look For What To Look For?
It’s so simple: Start from yourself.
That’s what I do.
I constantly self-reflect and when I find myself looking at the potential upside first, getting puzzled by the 10x opportunity before thinking of the downside, it’s a sign.
This is the easiest signal you could get.
Then look at others. If you see that everybody is constantly pitching new great ideas, it’s when you should turn more defensive than aggressive.
Does this mean that the market will crash just because people are driven more by greed than fear and they act more imprudently?
No, not always.
Think of it like getting distracted when you drive.
Sometimes you get distracted, you notice it and you pull your shit together by yourself, sometimes other people warn you and sometimes conditions are just good enough to tolerate carelessness like there is no other car to crash when you get out of your lane etc…
There are many reasons that the ultimate disaster won’t happen despite your distraction.
But when the disaster happens, it is necessarily caused by somebody’s distraction.
🏁Conclusion
If there is one superpower an investor would want to have, it’s to predict market crashes.
Thousands of smart people in the industry are constantly looking at many metrics and trying to understand if the crash is coming.
Yet, crashes manage to catch 99% of people off guard.
This is because we ignore a fundamental aspect of the market crashes by focusing too much on the numbers: All the disasters in the market are man-made.
This is because the market itself is a human production, it’s not a product of nature.
It’s a folly of human nature to assume that past data tells you much more about the current human behavior than simply observing it right now.
Let me ask you a simple question: If it rained in your city every Wednesday in the last three weeks, does this make all sunny current Wednesday more likely to rain?
Of course not. But looking out and seeing clouds form does.
This is what we should all do.
Instead of looking so obsessively at the numbers, we should look out to see if clouds are forming.
It doesn’t always rain when it's cloudy; but when it rains, it’s always cloudy.
How do we understand if clouds are forming over the market?
When we ask the upside before the downside, it’s time to get your umbrella.
So based on this do you think that the current correction is going to become a crash?
And separately, doesn’t this mean that you are going to end up backing out of the market pretty much all the time it goes up?
If there is a period of euphoria where the market goes up then you back out because people are optimistic and when the market stops being positive and things move downhill then you re-enter something that is dropping?
Doesn’t this just mean that you miss all the gains and only take losses or relatively flat periods?
Behavioral economics is such an underrated and important field. Thank you for writing this article!