For more than 13 months, investors have enjoyed a record-breaking bounce-back rally on Wall Street. Since the nearly 125-year-old Dow Jones Industrial Average (^DJI -0.18%), benchmark S&P 500 (^GSPC -0.65%), and technology-heavy Nasdaq Composite (^IXIC -1.16%) hit their bear-market lows on March 23, 2020, this trio has respectively returned 83%, 87%, and 103%.
But history tells us a different tale. If history is proved right, once again, a stock market crash may be coming.
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A case is mounting for a big drop in the stock market
The first thing to realize about stock market crashes and corrections is that they're really quite common. Optimists might dislike when they rear their head on Wall Street, but the data shows that a double-digit decline has occurred in the S&P 500, on average, every 1.87 years since 1950.
The biggest threat to the market at the moment might be historic valuation. As of May 3, the S&P 500's Shiller price-to-earnings (P/E) ratio was 37.53. This is a measure of average inflation-adjusted earnings over the past 10 years. Not only is 37.53 more than double the average Shiller P/E for the S&P 500 since 1870, but anytime the Shiller P/E has jumped above and sustained 30 throughout history, bad things have happened. In the previous four instances where the Shiller P/E topped 30 during a continuous bull market, the S&P 500 subsequently shed between 20% and 89% of its value.
History is also unkind to the S&P 500 in the three-year period following a bear-market bottom. Since 1960, there have been nine bear markets (a decline in the S&P 500 of at least 20%). In each of the previous eight bear markets prior to the coronavirus crash, there was at least one double-digit percentage pullback within three years after the bear-market bottom was reached.
Other factors stand out as potential bull-market wreckers, including the spread of coronavirus variants, increasing inflation rates, and the prospect of higher mortgage rates, which could quell a red-hot housing market.
Suffice it to say, there's a very real possibility a stock market crash is coming.
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5 things to do if a crash or big correction occurs
That's the bad news. The good news is that every single crash and correction throughout history has eventually been erased by a bull-market rally. This is a fancy way of saying that all major dips in the S&P 500, Dow Jones, and Nasdaq Composite have proved to be buying opportunities.
If a stock market crash or serious correction is in the cards, here are five things you'll want to do.
1. Understand your risk tolerance ahead of time
Before the next stock market crash or correction occurs, one of the most important things to do is understand your tolerance for risk. For example, buying tech stocks can lead to wilder vacillations than if you were to put your money to work in defensive companies, such as electric utility stocks. Likewise, there's often more implied risk and reward if you're buying individual stocks as opposed to investing in an exchange-traded fund (ETF).
Keep in mind, though, that taking the safer route doesn't mean sacrificing success. Everyone would love to beat the total return of the market. But if you had owned an S&P 500 tracking index since 1980, your average annual return, inclusive of dividends, is about 11%. With reinvestment, it'd take less than seven years to double your money since 1980. There's no shame whatsoever in that sort of return.
2. Reassess your holdings
Although you don't need to wait for a crash or correction to occur, a tumbling market is always a good time for investors to reassess their holdings. By this, I mean examining your initial investment thesis and determining if the reason(s) you bought a stake in a company still holds water today. There's a very good chance that a short-term, emotion-driven crash or correction in the market isn't going to have any bearing on your investment thesis or the underlying operating performance of the companies you're invested in.
On the other hand, if your thesis has been compromised on one or more holdings, this would be a good time to consider selling or reducing your stake.
3. Have cash at the ready
Third, you're going to want to have cash available to take advantage of any significant declines in the market.
However, don't worry about trying to time the bottom, because that's not something that can be done with any accuracy. The solace you should take while investing during an emotion-driven decline is that, since 1950, there have been 38 double-digit declines in the S&P 500. Every single one of these drops was eventually put in the rearview mirror, often within a matter of weeks or months.
What's more, a report from Crestmont Research found that the trailing 20-year total returns of the S&P 500 between 1919 and 2020 have never even come close to being negative. Translation: If you buy great companies or ETFs and hold for a very long period of time, you have a very good chance to build wealth.
Image source: Getty Images.
4. Don't forget about dividend stocks
If you're looking to put your money to work during a crash or correction, don't overlook dividend stocks. Mature businesses that pay a dividend may not offer the same growth rate or return potential as high-growth companies or small-cap stocks. However, they're often profitable and time-tested, which makes dividend stocks a safe bet during a market downturn.
Even more impressive is the long-term outperformance of dividend stocks compared to non-dividend payers. A 2013 report from J.P. Morgan Asset Management showed that companies initiating and growing their payouts averaged an annualized gain of 9.5% between 1972 and 2012. By comparison, the non-dividend-paying companies delivered a meager 1.6% annual average return over the same time frame.
5. Think value during the early stages of an economic recovery
Fifth and finally, consider putting your money to work in value stocks. While I know growth stocks have run circles around value stocks since the end of the Great Recession, it's value stocks that are the better performer over the very long term (1926-2015). According to a Bank of America/Merrill Lynch report in 2016, value stocks averaged an annual gain of 17% over 90 years, compared to 12.6% for growth stocks.
More importantly, value stocks tend to significantly outperform growth stocks during the early stages of an economic recovery, which is where we are right now.
If you're mentally and financially prepared, a stock market crash can be one heck of a moneymaking opportunity.
Bank of America is an advertising partner of The Ascent, a Motley Fool company. Sean Williams owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
