What Triggered the Crash?

"And so on to the moment of mass disillusion and the crash. This last, it will now be sufficiently evident, never comes gently. It is always accompanied by a desperate and largely unsuccessful effort to get out. The least important questions are the ones most emphasized. What triggered the crash?

This is not very important, for it is in the nature of a speculative boom that almost anything can collapse it. Any serious shock to confidence can cause sales by those speculators who have always hoped to get out before the final collapse, but after all possible gains from rising prices have been reaped. Their pessimism will infect those simpler souls who had thought the market might go up forever but who now will change their minds and sell."

– John Kenneth Galbraith

The title of this comment may seem odd, given that – as I write this on July 14, 2021 – the S&P 500 is at a record high. Indeed, based on the measures we find best-correlated with actual subsequent market returns, stock market valuations are easily beyond every level in history, including the 1929 and 2000 extremes. Of course, that’s exactly the point. While our investment discipline is to align our investment stance with observable market conditions, and requires no “forecasts,” I consider prevailing conditions to be strikingly hostile.

The first passage of the Galbraith quote above is from his 1990 book, A Short History of Financial Euphoria. The second is from his 1954 book, The Great Crash, 1929. If investors need one thing at this moment, it is the perspective of market history.

When the time comes to ask the question – “What triggered the crash?” – remember that this is the least important question. A market crash requires nothing more than a shift in investor psychology from careless speculation to even modest risk-aversion. A market crash requires nothing more than an increase in the risk premium demanded by investors, in an environment where risk premiums have become overly depressed.

At some point, enough investors stop basing their expectations for future returns on the mindless extrapolation of past returns, in a market where prices have become detached from fundamentals. At some point, investors discover a basic fact of equilibrium: it is impossible, in aggregate, for investors to “exit” the market. Every single share of stock that has been issued has to be held by some investor, at every moment in time, until it is retired.