I keep hearing people equating the stock market being down 10% with the world economy losing 10% of its value, or stuff like that. But I don’t think that’s the right comparison.
I think the 2008 recession cost the economy something like 5-10% of its long-term value. There were one of two years of below average growth (depending on if you’re looking at the US or the world), then one year of negative growth (2009), then things mostly returned to baseline. But the S&P 500 was down 50% in 2008. Were people just bad at predicting how bad the recession would be?
No, I think what’s going on is that in a crisis:
- volatility is higher
- people’s risk tolerance is lower
- people’s return on capital is higher
and these all mean that the premium you can get paid to hold risky assets goes up, ie stocks go down.
Does this mean there’s a trade to do? Well, yes, I think buying stocks in a crash is a positive EV trade on a year timescale or something. But it’s also risky; they’re much more likely than usual to go down a lot more, and cause you to get liquidated or lose a bunch of money, at a time when you’re much more likely than average to lose your job or experience other shocks that might create a need for capital. Matt Levine said something about this the other day:“Sure maybe a good time to buy stocks is when everyone is selling, but if people are pulling money from your fund and brokers are refusing to provide leverage, you’ll probably be selling too.“
But yeah, I don’t think the stock market being down 15% is nearly as bad as losing 15% of the future economic value in the world. If the average annual return of the S&P 500 is 8%, then a 3x in expected volatility should cause that alone, I don’t think volatility for the year is up that much (short term VIX is). But I think that and similar factors, rather than changes in expected future cash flows from the economy, accounts for the majority of the move in crashes.