Market sets new high on flash crash anniversary

(MoneyWatch) As I watched the S&P 500 index set a new all-time high yesterday, it struck me that it occurred on the third anniversary of the so-called Flash Crash. In case you forgot, on May 6, 2010, U.S. stock markets opened down and kept trending lower most of the day on worries about the Greek debt crisis. At 2:42 p.m., with the DJIA already down more than 300 points for the day, the stock market began to fall rapidly, dropping an additional 600 points in just five minutes, for an almost 1,000 point loss on the day. That fall was triggered by a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts and high-frequency traders aggressively selling accelerated the decline. However, the market regained most of the 600 point drop just 20 minutes later.

Just over two years later, on August 1, 2012, we experienced another flash crash as the stock market was roiled by a trading glitch at Knight Capital Group. At 9:30 a.m., while the broad market averages were fairly quiet, 150 stocks traded up to 20 times their normal volume, with many losing 10 percent or more in value in a matter of seconds before quickly stabilizing.

While the impact on the market was nowhere near as great as it was during the Flash Crash, it did convey to individual investors the sense that markets are spinning out of control and that the game is not a fair one. In his column, The Wall Street Journal's highly respected Jason Zweig pronounced: "If small investors needed any more reason to be disgusted with the stock market, they got it Wednesday." He went on to add: "Make no mistake: The hearts of many small investors have been broken by the serial setbacks of the past few years." He was questioning whether retail investors would call it quits.

Consider the effect of these crashes, coupled with forecasts such as Bill Gross's 2009 forecast of a "New Normal," which predicted years of stagnant corporate profits and lousy stock returns or Nouriel Roubini's constant doom-and-gloom forecasts. These events certainly contributed to investors pulling hundreds of billions of dollars out of stocks from 2008 through 2012. It was only at the very end of last year that investors began to add to their stock holdings. With that in mind, let's do a quick review of how investors who stayed the course performed.

The S&P 500 index has risen almost 500 points in just the three years since the flash crash close of 1,128, providing a total return, including dividends, of about 50 percent. Anyone think investors who stayed the course are disgusted with the market (as Jason Zweig suggested) and those type of returns?

There are two important lessons for investors. The first is that big bad bear markets -- whether in the form of "Black Monday," a flash crash or a financial crisis -- are the very reason why stocks have high expected returns. Because crises are the norm -- we have experienced one on average about every two to three years -- investors demand a large risk premium to accept the risks and all the stomach acid bear markets cause.

The second lesson is one that we repeatedly remind you about: Investors should ignore all market forecasts, even if they come from such well-respected investors as Bill Gross. As Warren Buffett warned, such forecasts tell you nothing about the market, though they tell you a lot about the person making them.

Image courtesy of Flickr user 401(K) 2013

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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