The next stock market crash will look a lot different from the financial crisis

  • The stock bull market is well into its ninth year, and signs of fragility have firms like Bank of America Merrill Lynch looking ahead to the next big crash.
  • By BAML’s calculation, the next bear market will be in line with past occurrences but nowhere near as volatile as the 2008, 1998, or 1987 crashes.

Stock bull markets don’t last forever, which is why it’s a useful exercise to start bracing for the next big crash. Or at the very least, it’s helpful to know what kind of damage could result from the inevitable downturn.

To do so, Bank of America Merrill Lynch looked at past S&P 500 bear markets – generally defined as a 20% drop – and analysed the volatility that has accompanied them. To the firm, the key is looking at the degree of price swings leading up to the crash.

And based on the fluctuations seen during the ongoing 8-1/2-year bull market, the firm forecasts volatility of 18% for the next large downturn, which is right in line with other “classic” bear markets.

Screen Shot 2017 12 06 at 4.05.35 PMBank of America Merrill LynchBank of America Merrill Lynch says that, based on the current bull market’s volatility, the next bear market will see volatility of 18%.

Of course, there’s always the risk of a rare occurrence that rocks the market and sends measures of volatility spiking. BAML notes that the Great Depression of 1929 and the global financial crisis in 2008 were driven by major systemic shocks, while Black Monday in 1987 and the collapse of the hedge fund Long-Term Capital Management in 1998 were caused by liquidity-driven meltdowns.

Fear not, BAML says. For one, the market does not appear at risk of another global financial crisis. The firm says the huge regulatory response to the crisis, bank deleveraging, and risk transfer to central banks have alleviated the pressures that contributed to that crash.

As for the massive sell-offs in 1987 and 1998, BAML argues that volatility today is simply too low to replicate those disastrous periods.

“History shows that a shock of this magnitude has never occurred from the current level of volatility,” a group of BAML derivatives strategists led by Benjamin Bowler wrote in a client note.

Screen Shot 2017 12 06 at 4.22.25 PMBank of America Merrill LynchBAML says that the current volatility regime is nothing like the ones seen before the 1987 or 2008 crashes and that therefore the market isn’t at risk of selling off to that degree.

But this doesn’t mean it’s time to get cocky. Just because the next bear market is likely to be subdued relative to the worst in history doesn’t mean it won’t be painful. After all, as BAML points out, “markets remain fragile.”

So as the bull market extends well into its ninth year, investors would be well-served to keep an eye on the risks that are still out there, lurking in the shadows. Luckily, Morgan Stanley has identified “three x’s” that could send stocks into bear-market territory: extreme leverage buildup, exuberant sentiment, and excessive policy tightening.

Got all that? Good. Now go protect to the downside, just in case.

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