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


Reuters / John Gress

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.

In order to do so, Bank of America Merrill Lynch looked at past S&P 500 bear markets - generally defined as a 20% drop - and analyzed the volatility that has accompanied them. To them, 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.

Bank of America Merrill Lynch

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 (GFC) in 2008 were driven by major systemic shocks, while Black Monday in 1987 and the collapse of hedge fund Long Term Capital Management in 1998 were caused by liquidity-driven meltdowns.

Fear not, says BAML. For one, the market is not at risk of a GFC repeat. The firm says that 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 selloffs in 1987 and 1998, BAML argues that volatility at present time is simply too low to match the conditions that preceded 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.

Bank of America Merrill Lynch

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 current 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 build-up, exuberant sentiment and excessive policy tightening.

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

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