A Silver Lining for Market Crashes

It has been a rough month for investors. The S&P 500 has fallen roughly 7% in the last month, or about 8% year-to-date. Though some of the events driving this volatility are unprecedented, the volatility itself isn’t. In fact, things could get a lot worse from here. Buckle up, we could be in for a bumpy ride. 

But does that mean you should move everything into cash? I don’t think so. 

The problem with doing so is that no one knows when markets will come back. You see, markets don’t necessarily perform well when things are good and go down when things are bad. They perform well when prospects look “better than expected,” and decline when things look “worse than expected.” Meaning, the economic picture could keep getting worse, and yet markets could rally simply because things aren’t going as badly as many investors feared. 

This is what happened in 2009. The market bottomed in March of ‘09, even though employment and GDP continued to deteriorate for a few quarters from then on. Some investors looked at that and thought the market was crazy. “Can’t it see how bad things are? A million more unemployed people, continued home foreclosures, shrinking GDP, and the federal government just acknowledged that our whole financial sector is essentially insolvent, and the market is going up?” What many thought was an unsustainable, sanguine rally turned out to be the beginning of one of the great bull markets in US stock market history. 

If you sell everything now, you might feel good about it for a few weeks or even months. Stocks could keep going down. And yet, there will almost certainly come a point when stocks come back faster than you can react. The big risk that comes from sitting in cash is that it makes it harder to buy the dip later on because each new decline further reinforces the apparent wisdom of your decision. Meanwhile expected returns going forward are continuing to rise. You feel smarter, but the actual smart thing to do at that point is to start buying stocks. 

Yes, the smart thing usually feels terrible. Wisdom is doing whatever makes your stomach clench. 

Here’s an illustration of what I mean. Imagine that stocks are on a long term trajectory of earning about 10% a year. Sometimes stocks get ahead of themselves, and sometimes stocks need to grow faster to catch up with that 10% trend. And that has historically led to some extra cyclicality. The S&P 500 tends to have long stretches where stocks do really well, and some painful times where they don’t. 

10% isn’t a magic number by the way. Here’s where it comes from. The S&P 500 has historically grown earnings at roughly 6% a year. For a long time, companies paid out more of their earnings as dividends, and the S&P 500 had a dividend yield of 4%. Add 6% and 4%, and you get 10%. 

More recently, companies have directed their earnings to buybacks, rather than dividends. This means they’re buying back their own stock in the open market. When done well, this increases your ownership stake in the business, and translates to higher earnings growth on a per-share basis. 

Near the end of 2024, the combined buyback yield and dividend yield totaled about 3.6%. So if we take that 3.6%, and add it to the 6% earnings growth average, and we get 9.6% expected returns. So we’re not far off from that 10% number. 

Now to get to the silver lining. 

For someone who is putting cash to work in the market, whether by saving or by rebalancing a portfolio of stocks and bonds, market declines are a great opportunity. For the sake of illustration, let’s say we expected stocks to return about 8% a year for the next 3 years. At the end of 3 years, you would end up with about $126 per $100 invested, or a 26% return, regardless of what path markets take to get there. 

At first blush, you might choose the path that offers a steady 8% return. After all, no one wants to see their stocks fall 24% or god-forbid 40%. But let’s look at what happens after stocks have fallen. Again, we’re looking at the same end point. 

If stocks have fallen 24%, $100 would be worth $76. To hit that $126 figure two years out, stocks would grow 65.79%. Meaning, if you bought at the bottom, when things looked bleakest, the dollars you put to work at that time would grow by 65.79%. That beats the pants off the measly but smooth 26%. 

But it gets even better than that. Suppose stocks fell 40%, $100 would be worth $60. Oof. In this case, recovering to that $126 level gives a 110% return. Woo-hoo! The dollars you put to work at that time of despair would grow by more than double! 

Let’s say you’re a retiree who needs growth, income, and security. Wouldn’t a 65% return help you with all three of those? If you have cash, bonds, or some other less depressed asset in your portfolio, drawdowns are a great time to put some of that money to work. And so, if you’re a retiree with, say, a 50/50 portfolio (50% stocks, 50% bonds), there should be some part of you, rationally, that looks forward to a drawdown with eager anticipation. 

Here’s what that looks like if you rebalance after a crash. 

For a 50/50 portfolio, rebalanced after stocks have fallen, where bonds return 4%, and stocks follow the patterns above this is what you get. 

For the scenario where stocks do a steady 8% a year with no drawdown, you end up with $119. 

When stocks drop 24% then recover, the portfolio grows to $123. 

When stocks drop 40% then recover, the portfolio grows to $130. 

That’s right, the biggest initial decline actually delivers the most wealth in the long run. 

Yes, drawdowns are painful in the short term. But the author of Psychology of Money, Morgan Housel says, “every future (and current) crash looks like a risk. Every previous crash looks like an opportunity.”

To summarize, we don't know when stocks will come back. But we can be certain that when stocks begin their recovery the outside world will still appear to be getting worse. It just won't be getting as bad as fast as markets originally thought. We also know that when stocks decline, that their expected returns going forward go up. It's just a matter of how low they go, and how high those forward returns go. The Great Financial Crisis of 2008/2009 saw the S&P 500 drop over 50%, after which the market delivered 16 years of stock returns averaging about 15%, well above their long term trend. $100 invested at this time would have turned into over $900.

Finally, we know that drawdowns can be a great time for buying stocks, not selling them. And if you do so, the data suggest that you'll end up with more money in the long term than you would have without the crisis.