Exploring the Possibilities: Gauging the Likelihood of a Stock Market Crash

You’re likely overestimating the chances of the stock market experiencing a crash as severe as the one in 1987 in the coming months, which has caught the attention of contrarians. While it’s understandable for investors to be concerned due to numerous analysts pointing to a potential market bubble, the probability of a crash of similar magnitude to 1987 in the near future is quite small—just 0.33%.

We can gauge the average investor’s crash probability perception through a survey conducted by Yale University’s Robert Shiller. The survey distills results into a single number representing the proportion of respondents who believe there’s a less-than-10% chance of a 1987-like crash in the subsequent six months. The latest survey shows this number at 33.9%, indicating that 66.1% of investors see the risk as higher than 10%. This uptrend in perception is evident in recent years, with the 24-month moving average rising from 64% in 2015 to 74% today, slightly down from last year’s peak of 77%.

Actual crash probabilities were studied by Harvard’s Xavier Gabaix and Boston University’s Center for Polymer Studies researchers. Their formula predicts crash frequency, and when applying a one-day 22.6% drop, equivalent to Black Monday in 1987, the probability of such a decline is 0.33%.

Investor concerns have grown partly due to the occurrence of two bear markets in quick succession—early 2020 and 2022. This rarity has dimmed long-term investor outlooks. Research by Camelia Kuhnen from the University of North Carolina highlights how investors react to losses with more pessimism than gains generate optimism. This psychological bias, known as “pessimism bias,” lingers, even when markets subsequently perform well. Shiller’s crash-confidence index, a potential contrarian indicator, has shown that periods of higher crash worries correspond to better market performance over one-, three-, and five-year periods.

While the crash-confidence index might not predict short-term market movements, its strength lies in forecasting a robust market performance over several years.

Leave a Reply