Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell. Xavier Gabaix, a finance professor at New York University, has derived a crash-frequency formula that he believes captures a universal trait of all markets, not just equity markets or those in the U.S. According to that formula, the odds of a 12.8% crash in any given six-month period are 0.92%, almost as low as the actual frequency in the U.S. stock market over the last century.
These factors are unable to account for all of investors’ exaggeration of crash probabilities, however, since at no point did the average individual investor believe those probabilities to be lower than 13.5%—17 times higher than the probability based on historical frequencies alone.
Warren Buffett ‘s favorite indicator is the Market Cap to GDP Ratio, which, as the name implies, compares the total price of all publicly traded companies to gross domestic product (GDP), the implication being that stocks and their valuations should bear some relationship to the benefits of investing or not investing.
Stock market risk increased dramatically, as indicated by the trend in volatility on Figure 1 Even those who do not follow the stock market could become more uncertain about the future of the economy in general and the stock market, in particular, as general uncertainty has been in the air” throughout the crisis.
The payments you receive from these investments stays the same each year, but inflation (rising prices) in the market causes those payments to have the ability to buy less and less each year. Regardless, investors no longer regarded high corporate profits and dividends, high wages, readily available bank debt , a booming auto industry and a relative lack of stock market regulation solely as signs of better days ahead.