How to Spot and Avoid the Next Crash

We speak with Dr. Linda Yueh CBE, Adjunct Professor of Economics at London Business School about financial crashes and what investors may want to know about them. Dr. Yueh shares the three phases of every financial crisis, and how we can spot and avoid the next crash.

Why do financial crashes happen and how often do they happen?

It’s human nature to be optimistic and believe that the value of an asset, whether that’s stocks or real estate or something else, will rise and rise. History teaches us that it’s hard to tell if it’s an increase in fundamental value or a bubble. But history also makes clear that busts always follow booms, so it’s important to beware of fueling that euphoric belief with too much debt.

My book, The Great Crashes: Lessons from Global Meltdowns and How to Prevent Them, tells the story of 10 great crashes in the past century, and it’s apparent that financial crises occur with alarming frequency. All crashes are different but share similar traits. And there’s where the lessons are found.

Is there a specific crash that stands out to you? Are there any that’s relevant to today’s environment? 

There are two crashes that we could learn lessons from that would be highly relevant today. The savings and loan (S&L) crisis of the 1980s and the dotcom bust in the early 2000s. The S&L crisis was a slow-burn crash of mainly community banks that had invested recklessly in commercial real estate that ended up becoming the worst banking crisis until the 2008 sub-prime crisis. The dotcom crash led to a recession and it took the stock market about a decade and a half to recover to its pre-crash level. Today, there is an ongoing crisis among a number of mid-tier banks, and there are concerns over commercial real estate.

Do you see a financial crash happening soon? What could cause the next crash?

Both of the above asset classes and others such as those related to the shadow banking sector, are all candidates for the next crash. Of the ten great crashes whose stories I studied, four occurred in the 21st century. The speed of transactions in the financial sector and the interlinkages among markets mean that the next crash could either be happening now or be just around the corner.

The lesson to learn from historic crashes are the ways to try and ensure that they do not become great crashes.

How can we avoid the next crash? 

We can’t, but if we can learn the lessons from history, then the inevitable next crash need not become a financial meltdown. There are three phases of every financial crisis, namely, euphoria, credibility, and the aftermath. The first is an exuberant belief that prices can ever only go up and investors do not want to miss out. The second is how the inevitable bust is resolved. It is only through credible policies deployed quickly that a crisis can be ended without causing economic devastation. The third and final phase is the aftermath, which varies greatly depending on the type of crash including the extent of debt as well as the credibility of the policies and policymakers.

Each phase holds lessons about how to avoid the worst of the next crisis as it’s not possible to prevent the next crash, but learning the lessons from history can help prevent it becoming a great crash that triggers a recession.

How do we spot the next crash?

Every financial crisis is a result of too much debt in some shape or form, so monitoring the amount of debt that’s fueling an exuberant increase in asset prices is a signal that there’s a potential bubble. Some bubbles deflate or even burst without dragging down the economy and causing a financial meltdown.

For instance, Black Monday in 1987 was the worst one-day crash to date but did not lead to a recession. Since 1970, of the 15 bear markets in the U.S., 11 coincided with recessions. So, a financial market crash does not necessarily lead to a recession, even though each recession is accompanied by a stock market decline. By spotting the next potential bubble, history tells us that it’s possible for it to deflate rather than become a great crash.

What should individual investors keep in mind? 

There are various things that investors should bear in mind. Firstly, my three-step framework described above can help investors spot the next crash as well as how it might be resolved. It’s worth noting that in each of the 10 precautionary tales that I tell in the book, there are investors and companies that not only survive but thrive after a great crash.

For instance, Amazon emerged from the dotcom bust stronger than before. These sorts of successful strategies are certainly worth bearing in mind as we will surely face another crash.

This interview originally appeared in our TradeTalks newsletter. Sign up here to access exclusive market analysis by a new industry expert each week. We also spotlight must-see TradeTalks videos from the past week.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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