- A stock market crash occurs when economic forces and investor panic floods the market with extra liquidity and drives down stock prices
- In 2020, the crash was precipitated by virus concerns and economic shutdowns, followed by mass layoffs and one of the shortest “official” economic recessions in history
- It’s possible that the stock market may crash again in 2021 – though investors also have plenty of reason for optimism, too
- If the market does crash, it’s often prudent to look toward defensive stocks to weather the storm, followed by growth and some cyclical stocks to ride to new heights
With the delta variant growing more prevalent, mask mandates cropping up, and the workers’ return to the office shunted off to at least 2022, it’s reasonable to ask whether the stock market will crash again in 2021. Although the S&P 500 hasn’t seen a single correction event (when the market dips 10% from its 52-week high) in nearly a year, the market appears ripe for a drawdown of some degree.
Therefore, the question for many investors is not if, but when and how bad.
What Causes a Stock Market Crash?
A stock market crash occurs in two parts.
First comes the catalyst, such as a speculative bubble bursting, major economic downturn, or catastrophe (such as a global pandemic). Then comes panic – specifically, investor panic – that increases liquidity in the market and depresses prices. In most crashes, these parts feed on each other to drive shares down to unprecedented lows.
Let’s look at this on a small scale.
Remember: stocks are, in essence, a tiny portion of ownership in a company. As such, their price is determined by how well investors believe the company will perform, along with the value of its assets. When investors have faith in the company, prices rise and profits flow. But when investors’ confidence is shaken, they exit their positions, which floods the market with shares and drives down prices. Other investors see their gains decline and panic, leading to a sell-off as they flee a sinking ship.
Now, let’s expand this to the entire market.
When the economy performs well and prices are, on the whole, rising, investors feel comfortable pouring their money into stocks. But when a catastrophe occurs and enough investors – or a big enough investor – fears losing their capital, they pull out before their profits shrink. This sends shares tumbling into the open market, pulling down prices overnight and the other panicking investors sell off their portfolios. As the panic-selling continues, prices sink ever-lower, and the last investors to the party lose more and more money.
This process, when it cascades long enough, is what causes the market to “crash.” And while it creates a buying opportunity for the brave and well-informed, it also leaves thousands of investors worth less than when they started.
Why Did the Stock Market Crash in 2020?
So, why did the market crash in 2020? The answer is multi-faceted, but not overly complex.
In early 2020, as news of the virus – and the virus itself – spread, governments around the world struggled to respond effectively to this new threat. And as we moved into the latter half of February, many grew wary of how the virus might affect their portfolio performance down the line, which led them to sell their shares. When March rolled around and the first government mandated shutdowns lent substance to their fears, the dam broke – and the market, predictably, plunged.
As investors watched their portfolios lose 30% or more in value between February 12 and March 23, many panicked and started selling faster. Others held onto the shreds of their tattered retirement accounts and bemoaned their life’s savings dripping down the drain. And at its very worst, during the two weeks between March 12 to March 23, the New York Stock Exchange suspended trading repeatedly.
Consequences of the 2020 Stock Market Crash
All in all, the virus triggered a bear market (a loss of at least 20%). This then gave way to an economic recession. While job losses and viral outbreaks continued through the summer and into 2021, the recession itself was the shortest on record. It spanned just two months. Ultimately, all three major stock indices closed up for the year. The Nasdaq gained the most at 43.8% returns in the twelve-month period.
But, considering that we’re still feeling the economic ripples of the crash now, why is the market continually cropping up with new record highs? The answer lies in the disconnect between the stock market and the economy, as well as how the government responds to this disconnect.
In oversimplified terms, the economy performs only as well as the individuals in the economy – both people and businesses – make it perform. They do this by producing and buying goods and services, paying wages, and sending money flowing through various channels.
By contrast, the market performs as well as investors believe it will perform. this is indicated by where they invest (or don’t invest) their funds. As such, those beliefs translate into very real results.
So, when layoffs and non-essential shutdowns began, the CDC and Congress stepped in with eviction moratoriums, stimulus checks, and loans to float the economy. Meanwhile, the Federal Reserve slashed interest rates and launched fiscal stimulus programs to assuage investor panic.
In other words, Congress kept the economy from sinking. But the Federal Reserve created an investment ecosystem ripe for reaping profits.
Will the Stock Market Crash in 2021?
Stock market crashes aren’t uncommon – in fact, there are several on record, ranging from the Great Depression to the Great Recession in 2008. And with so many to look back upon, there’s plenty of precedence to consider when answering this question.
Strictly historically speaking, every rebound from a bear market comes with its own choppiness and inherent risks. In fact, all eight bear markets between 1920 and 2020 featured at least one double-digit correction within three years, with five of the eight seeing two double-digit declines.
Another potential point of concern is what’s known as the S&P 500’s Shiller price-to-earnings ratio, which accounts for inflation-adjusted earnings over ten years. And as of the first week of September, the current Shiller ratio sits at 39.07, up from the early August P/E of 38.5. And in the most recent four occurrences of the Shiller P/E ratio sustaining a prolonged run over 30 points, the S&P fell into a bear market shortly thereafter.
Of course, neither of these metrics guarantee that the market is going to fall. In fact, the S&P 500 has given no indication of a major drawdown since midsummer. And just because history says the market will crash doesn’t mean it’s going to…necessarily, and even if it did, wouldn’t pinpoint when a crash would happen. Of course, there are reasons to examine the risks – but there’s plenty of room for optimism, too.
Optimistic Outlooks in the Current Market
- Vaccines. Although the vaccine didn’t end the pandemic, it did curb its effects. And with Pfizer gaining full FDA approval for its vaccine, many businesses and government departments have laid down vaccine mandates. Or financial consequences.
- Economic reopening. As the world reopens, many reopening-dependent stocks are regaining their prices, leading to potential upsides. Such as travel, entertainment, and oil.
- The new normal. Many industries have cemented their place (at least temporarily) as the new golden child(ren) of investing. Like tech, biotech, and ecommerce.
Risks in the Current Market
- Covid-19. Though the virus was once in decline, new mutations and pockets of unvaccinated populations have led to a resurgence in hospitalizations and deaths.
- The Federal Reserve. Jerome Powell recently announced that the Fed is looking to taper its bond buyback program before the end of 2021, concerning some investors.
- Inflation. Rising inflation also worries investors as pressures like shipping delays and the ongoing chip shortage remain beyond any one agency’s control.
- Unemployment trends. Though many workers have graduated into higher-paying jobs in some industries, other sectors remain severely understaffed.
- Profits. Dozens of companies posted record high profits in the last two quarters. But these same companies also warned that upcoming quarters may see less profits, or even declines. That’s thanks to high year-over-year comparison metrics and slowing business trends.
What to Do in the Event of a Stock Market Crash in 2021
But if the market does crash again in 2021, you should know how to protect your future. Instead of panicking with the other investors, keep a cool head about you. Capitalize on the myriad buying opportunities at your disposal. The key is to invest in high-quality securities when stocks are cheap. Rather than trying to time any ole stock (or the market at large).
But which stocks make the best opportunities vary based on the situation and your risk tolerance.
For instance, those with low risk tolerance or who seek profits may benefit from going in on dividend-paying stocks. Think: utilities, healthcare, consumer staples, and large, slow-moving tech companies like Apple. While you may not get rich off these securities, that’s not the point. The point is to buy them cheap so you can preserver your capital during wild swings in the future. And if you want to go in on utilities with additional upsides, consider renewables and innovative designs that may pay off in the future.
But aggressive growth-seekers may look toward tech stocks. While some giants have lumbered into value and dividend territory – see Apple above – the bulk of tech has not. The bulk is focused on innovation, profits, and being the next big thing. Possible niches to consider include cybersecurity, ecommerce, chipmakers, financial technology (FinTech) companies, and cloud providers.
And for those wanting to capitalize on their positions after a crash-recession, some securities provide rock-bottom lows with potential upsides. Like combination, leisure, travel, hotel, restaurant, and entertainment securities. They key, of course, is to invest in the right stock at the right time. Especially as recovery stocks are often slow to…well, recover.
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