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Here's the irony of trying to predict the next stock market crash

Sam Ro
Managing Editor
The curb outside the American Stock Exchange where panic began. (Image: Wikimedia Commons)

When volatility spikes in the financial markets, so does fear of an impending market crash. This fear went parabolic last month as the UK unexpectedly voted to leave the European Union. In the days that followed, markets around the world sold off sharply.

"Feelings of 'This is it!' rise again," Oppenheimer's Ari Wald said.

Ironically, history shows that fear of a crash has a poor track record of predicting crashes. Conversely, some of history's worst crashes came when no was expecting one.

"We continue to note that the sentiment backdrop is far from extreme optimism and instead quickly shifts to gloom and doom during market downturns," Wald wrote in a note to clients. "We saw this again last week as shown by a spike in the number of news stories referencing the words 'Stock Market Crash' to its highest level in years. For comparison purposes, there were significantly fewer occurrences of this through the topping process in 2007."

In other words, very few people were looking into stock market crashes before the last big crash actually happened.

More people are searching for stock market crash today than they did before the last stock market crash. (Image: Oppenheimer)

"Our view is that with many investors seemingly eager to call the next market crash, the risk of one is likely not yet significant," Wald said.

Yale School of Management tracks this fear through surveys, which feed into the school's proprietary Crash Confidence Index. The index represents the percentage of respondents who think there's a less than 10% probability the market crashes in the next six months.

Similar to Wald's observation, Yale's Crash Confidence Index showed that many folks didn't fear a crash as the stock market peaked and tumbled from 2007 through 2008.

Periods of low crash confidence have been historic buying opportunities. (Image: Yale School of Management)

"Crash confidence reached its all-time low, both for individual and institutional investors, in early 2009, just months after the Lehman crisis, reflecting the turmoil in the credit markets and the strong depression fears generated by that event, and is plausibly related to the very low stock market valutions then," Yale analysts observed. "The recovery of crash confidence starting in 2009 mirrors the strong recovery in the stock market."

In other words, the bottom in the stock market coincided with peak fears of an impending market crash.

Some of Wald's peers on Wall Street are coming to similar conclusions that the fear these days may be overblown.

“In June, the Sell Side Indicator — our measure of Wall Street’s bullishness on stocks — fell for the third month in a row to 50.7 (from 51.6), its lowest level in three years,” Bank of America Merrill Lynch’s Savita Subramanian said on Friday. "The indicator is now firmly in 'Buy' territory … While sentiment has improved significantly off of the 2012 bottom — when this indicator reached an all-time low of 43.9 — today’s sentiment levels are still well-below where they were at the market lows of March 2009.”

BAML's Sell Side indicator is now firmly in “Buy” territory. (Image: Bank of America Merrill Lynch)

Subramanian says this indicator, which is based on recommended equity allocations among Wall Street strategists, is predicting a 12-month total return of over 21% for the S&P 500 (^GSPC).

Over at Citi, strategist Tobias Levkovich sees a similar signal coming from his firm's proprietary Panic/Euphoria model, which is based on various market measures of sentiment.

“[S]entiment remains quite poor, similar to the lows in 2011-12 when investors should have been buying stocks,” Levkovich said following the Brexit vote.

Some of the best times to buy stocks is when panic hits the market. (Image: Citi Research)

Of course, history is just a guide, not gospel. Indeed, we can never completely rule out the possibility of an impending crash.

But investors should always remember that when it comes to risk in the markets, it's always something.  And oftentimes, bouts of uncertainty end up being uncomfortable buying opportunities that can pay off generously over time. That's just the inconvenient truth about the stock market.

"Be fearful when others are greedy and greedy only when others are fearful," Warren Buffett said.

Sam Ro is managing editor at Yahoo Finance.

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