One of the biggest risks in investing is a behavioral concept called recency bias. Markets crashed last month, so they’re sure to crash again any moment… right? Well, actually, market crashes tend to be rare and far apart from one another in time. However, we wouldn’t blame someone for still being on edge over what the market might do next, that’s totally normal. But the evidence in the market suggests positive returns following sharp losses like what we saw in early April. We also note positive developments for the AI trade, which continues to have a large impact on stock market performance.
Being mindful of recency bias
Our minds are wired to take our most recent memory and extrapolate it out as expectations for the near future. Yes, you could say stocks crashed after President Trump’s tariff unveiling, falling 15% from April 3-April 7th. But, the crash is already over.
In fact, markets have been “crashing up” for the last month, and are up more than 20% from their April 7th low. Stocks are higher today than they were heading into the year. Furthermore, the historical evidence suggests that stock market crashes rarely happen in quick succession of each other. Instead, crashes tend to mark the bottom of the stock market and are usually followed by strong returns.
The table below looks at two day drops of 10% or more in the S&P 500, like what we saw on April 3rd and 4th. We find that following similar instances, the S&P 500 rose an average and median of 32.60% and 22.90%, respectively:
The next dataset analyzes S&P 500 returns after the VIX spends time above 30, a level associated with major stock market volatility. Following 28 similar instances, S&P 500 has posted average returns of 24.90% over the next year:
If we look at the last few decades, we see the S&P 500 has fallen 20% or more in the following years or stretches: 2022, 2020, 2007-2009, 2000-2002, 1987, 1980-1982. This does not point to a frequent pattern or cluster of stock market crashes.
Consider the catalyst
We must also consider why the market fell so dramatically… what was the catalyst? Or, perhaps it’s better to first consider what was NOT the catalyst. The market did not fall last month because:
- The unemployment rate spiked
- Corporations reported a dramatic slow down in profits
- Consumers fell behind on mortgage payments at alarming levels
- A pandemic broke out (sorry for the 2020 reminder)
- War broke out close to home that involved the US military
- Large banks failed
None of those things happened… Instead, the market sold off in response to a tariff policy that was judged to be detrimental to the economy. In effect, the market gave a real-time warning to President Trump that if tariffs stayed enacted at such aggressive levels, then the unemployment rate would climb, corporate profits would slide, and consumers would feel the pinch.
Luckily, President Trump heeded the market’s warning and backed off of his tariff policies just as dramatically as he enacted them. Simply put, the catalyst that caused the stock market sell off has been taken off the table. Will stocks go back down? Of course, normal 3-5% gyrations are par for the course and happen an average of two to three times per year. But we expect the market can stay on an upward trajectory from here, overall.
The AI trade firms back up
A main reason for our optimism is the encouraging action we are seeing from the AI trade. We have noted for the last two years, and as recently as last month, that key stocks like Microsoft, Apple, and Nvidia, will go a long way in dictating the market’s movement. That’s because these three stocks account for nearly 20% of the S&P 500 index, so they have a large impact on the day-to-day performance of the index. Here is what we wrote last month:
Today, Microsoft is at $450, Apple is at $210, and Nvidia is at $135. In the case of Microsoft and Nvidia they are approaching their highest levels of the last 12 months. This is an encouraging sign that the market is getting excited about the AI trade again. This excitement could manifest itself into new highs for these bell weather stocks while bringing the markets along for the ride.
In summary, the risk of recency bias may have many investors waiting for the next shoe to drop in the market. However, if you were worried about the market crashing, you already survived the worst of it. The historical evidence, along with improving performance from key stocks, suggests the market can keep rallying this year, normal gyrations notwithstanding.
Don’t want to miss anything?
Subscribe to our monthly newsletter for market insights.
