This is What “Always” Happens Before a Market Crash

What happens before a market crash? What is it that triggers a downturn that goes beyond just a bubble bursting and into a full-on generation-defining financial downturn? Like in 2008, when mortgage-backed securities caused the biggest housing bubble the world has ever seen, which burst when delinquencies rose past 79%, causing housing prices to plummet by as much as 40% in some markets. The big cities were hit especially hard. Or the crash that led to the Great Depression, which left one in four Americans unemployed and led to widespread homelessness. But most crashes don't come out of nowhere. The fear of waking up with your investments dropping and your savings at risk, it's real. But there are always signals that show up before the crash. And if you know what to look for, you can avoid being caught off guard. So in this video, I'll show you the four patterns that always show up before a crash and what smart investors can do to prepare based on what the data says is happening in the market today. So to understand the patterns of market crashes, let's start with the oldest market crash that we have a record of. One that predates computers, Wall Street, and even the combustion engine, going all the way back to 1634 in the Netherlands. Because the psychology that drives market crashes, it hasn't changed in 400 years. And we'll work our way forward through the great crashes of history to find the patterns that go way beyond the latest news cycle. So 1600s, the Netherlands. They've become independent from Spain, launched the East India Trading Company, and invented the world's first stock market. It's still a young country, but they are already dominating global trade. Kind of like the US in the post-World War II period up until today. This was the Dutch Golden Age, a period of huge economic growth. So as wealth floods into the Netherlands, they build the world's first stock market. And soon after, they'll experience the world's first documented market crash. And every crash has its own story, but the same four patterns show up again and again. And this one in the 1600s revealed the first one, rampant speculation and investor overconfidence. Now the causes of this first crash seem obvious in hindsight, but they always are. That's why it's worth seeing how this played out from their point of view. So in the 1600s, the tulip flower was exploding in popularity. These flowers were considered very rare and they became a status symbol in a developing economy that suddenly had a lot of money to spend. And these tulips would be at the center of the first market crash. At first, these were just expensive flowers that wealthy buyers used to impress their social circles. This one historian, Edward Chancellor, estimates that one pound of tulips sold for roughly an average month's salary at the time. That would be like paying $3,300 for flowers in the US today. That is pretty steep, and I can understand why people had portraits made flexing their tulips like it's a Rolex on Instagram. Some things never change, I guess. So tulips were very expensive, but they also were very rare and valuable. But then things got weird. People started paying more and more for these expensive flowers. And as prices rose, more merchants jumped into the market, not just to buy, but to trade. Everyone wanted a piece of the hot new trend. But then the Netherlands invented a new type of financial instrument called a futures market, which is still a standard part of modern markets today. People could now buy contracts to lock in a price today for flowers that they would get next season. But the price of tulips kept going higher, driven by a tulip mania. And soon, those agreed-upon prices ended up being a bargain. So if my contract says that I can get tulips for $3,300, but the price of tulips are now $30,000, the contract itself starts to become valuable. And that $30,000 price, that's not an exaggeration. That is an actual estimate of the value of tulips converted to a modern salary. So people started trading these futures contracts themselves, flipping paper and not the flowers directly. And this kind of looks like some stuff that's happening today. So people start paying more and more for these futures contracts, confident that they can just flip them in a few days to someone else for a higher profit. Overconfidence. The price of tulips keeps on rising. At its peak, some go for as much as five years of average salary. That's like paying $200,000 for tulips today. That's the kind of money you'd put into a home, not into flowers. And investors assume the market will keep going up forever because, hey, even if prices drop, you can take your rare tulips and grow more of them when the next boom comes. At least, that's what people were telling themselves. This is the irrational exuberance stage, when investors drive prices upward while ignoring the real value and risks, like the risk that maybe people just won't value tulips as much in the future. Eventually, the bubble had to burst, and it did. And when it happened, it brought down tulips prices, but also the entire futures market and the value of the land used to grow tulips. Everything tied to the boom was gone. But before the crash, everyone thought that the tulip was different. A satirical pamphlet from the time described the mood pretty well. If you are paid as well as you hope, that's fine, but many a plowman has high hopes when he sows his grain and all he reaps is stubble. And I love this response from a tulip grower, who says, no, this is too sure of a business for that. Come now, have a drink. Here's one for you. Getting drunk on hope and ignoring the risks is a good way to summarize the first pattern, investor overconfidence. But now let's jump forward in time a few hundred years to look at the second pattern that appears in every market crash. Okay, pause for a moment because I need to thank the sponsor of this video, boot.dev, who helped support the channel. So one of the best ways that I personally prepare for a market crash is by increasing my earning power. That way I have money on the sidelines if the market tanks. And if you're looking to increase your income, learning to code is still one of the best moves you can make. According to the latest Stack Overflow survey, developer salaries in the US are still firmly six figures. 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Go to boot.dev to start growing your skills and your income so that when the next market crash comes, you're ready to invest more. All right, back to the next pattern that shows up before nearly every market crash. So next we need to move forward in time to just before the greatest market crash of all time that led to the Great Depression. So the next part of the story and the next three crashes all draw heavily from this book, A History of the United States in Five Crashes by Scott Nations. So the 1920s marked a major turning point for the stock market. Telegraphs and later telephones made trading faster than ever. And just two decades earlier, the US had already experienced a warning shot with the market downturn known as the Panic of 1907. But the author of this book argues that the next pattern that is seen in every market crash is some kind of regulatory shortcoming. That's when those in charge either wait too long to respond to a new financial trend or step in too late and too hard. So the Panic of 1907 is a good example of the latter, where Teddy Roosevelt came in busting the investment trusts after they had already grown too powerful. And so his reforms were aimed at fixing the system, but the sudden pressure helped trigger the 1907 crash. But in 1929, the problem looked very different. The market had grown quickly and the guardrails hadn't kept up. And without a clear framework, speculation ran wild. So in 1907, they acted too late, and in 1929, they barely acted at all. And this historical pattern can tell us a lot about the modern market. So it was the Roaring Twenties. The Industrial Revolution had brought about more wealth than any previous period in history. It was a time of excess, the era of the Great Gatsby, but it wasn't going to last. See, a new type of financial company had been invented called a leveraged investment trust. These weren't just normal investment funds that pooled investor resources together. These companies took out debt on top of their investors' money, which meant they could make much bigger bets using the debt or leverage to magnify their gains. Of course, it would also magnify their losses. And now with leveraged investment trusts, even regular investors could buy stocks using debt. And I mean, why wouldn't they? The common wisdom at the time was that markets always go up. So if I put on my 1920s hat, kind of looks like a 1920s hat. I mean, sure, we've seen stock market crashes before, but it's the 1920s, the modern world. And the stock market is creating the world's first millionaires. Plus my stock broker, he knows what he's doing. The technology these guys have is crazy and they have super advanced financial models to make sure everything works out. We're living in the future. It's 2025, I mean, 1929. And I've got a financial broker, he's super sharp. And he says, if I just borrow more money, that means my stocks will go up even faster. And the government, they weren't super concerned either. The economy looks great and that's what keeps politicians in office. All right, and if I do my best 1920s bureaucrat impression, I mean, to be honest, I don't even know what these bankers do, but they've made me a heap of money in my investments. So I really just don't wanna mess up a good thing. So if you remember back to grade school, this was the laissez-faire era of government policy, which was to basically let the markets run themselves. Just don't trigger another panic like in 1907. And president Calvin Coolidge even says at the time, the chief business of the American people is business. So this is a pattern that we'll see again. So the big banks keep piling on debt, making bigger and riskier bets. And why not? These leveraged investment trusts, which are really just stock funds with debt stacked on top, start trading at double the value of the stocks that they actually own. This would be like buying a hedge fund today that is worth twice as much as all their investments combined. At this point, the goal isn't making returns. It's convincing more investors to sign on with their funds so that they can pump up their valuations. It was at this point that one little girl from Kansas mailed $4 to the Standard Oil Company to get in on the boom, and readers chipped in until she could afford a single share. So everyone's in the market. Shoe shiners are starting to offer hot stock tips. One writer even declares, But it wasn't built to last. In 1929, the stock market collapsed, dropping 89% in the years that followed. It was the biggest crash in history. That little girl's Standard Oil stock, by the time she actually got her shares, it had already dropped 15%. It would be down another 10% the next day. And what followed was a full-on depression. One in four Americans unemployed, families losing everything. Cheap credit from the Federal Reserve helped inflate the bubble, and the new debt-fueled investment industry drowned everyday investors in false confidence. Now this crash, like all the ones we'll look at, was driven by all four market patterns. But after this downturn, the U.S. government responded with the Banking Act of 1933, also known as Glass-Steagall, which separated the commercial banks from the investment banks and introduced FDIC insurance so people couldn't just lose their deposits because a bank made a bad bet. And regulators learned a lesson. It's not about do you regulate or not, it's about the balance between stifling growth, like in 1907, and allowing instability to build up, like in 1929 or back in the 1600s. And that is still true today, anytime you see a new industry pop up. But there are still two more ingredients in every major market crash. And this next one is the trickiest to spot because when you're in it, it hardly even feels like a problem, but it keeps on reappearing before every crash, and it's actually a pattern that I've seen in today's market multiple times. So now we jump to the 1980s, Wall Street's golden age of greed, and the perfect setup for this next pattern. The late 1970s and 1980s were sort of a turning point for Wall Street. Bankers went from back office number crunchers to some of the richest people on earth. And at the center of that shift was a new way of doing business. The rise of computers made it easier than ever to create new financial products. Big banks started inventing more and more new ways that hedge funds and pensions could invest outside of just boring old stocks. And if your bank was the first to roll out the next big thing, you'd lock in massive profits and your bonus would go through the roof, even if it hurt investors. This is similar to what we saw in 2008 because the third pattern before every market crash is a new, poorly understood innovation. In the 1980s, that innovation had a deceptively simple name, portfolio insurance. But that one innovation would lead to the worst single day drop in stock market history. So it started when two professors from Chicago and MIT, Black and Scholes, wrote a paper that inspired the idea of portfolio insurance. The basic version, if the market dropped, your bank's computer would place tiny trades betting against the stock. That way, if the stock kept falling, those trades would reduce your losses. It was kind of like a seatbelt for your investments. But the exact setup was complicated. So complicated, in fact, that even the banks themselves didn't fully understand how risky it could be. But whenever you see these kinds of innovations, at the time, they feel revolutionary. I mean, computers could now protect your investments from dropping by just creating their own algorithm. By 1987, over $80 billion was being run through these models. Banks trusted it, investors loved it, but beneath all that confidence was a system that was built on a lack of understanding. Now, this is when we see patterns start to overlap and interact because portfolio insurance by itself was not going to crash the market. See, the 1980s were also the era of the leveraged buyout. Hostile takeovers, quick flips, and fortunes being made overnight. Investors like Carl Icahn became celebrities, flipping companies for billions in profit. And regular investors paid attention. There ended up becoming a mania around these leveraged buyouts where investors would buy into a stock, hoping that someone would come in and flip it for a higher price. It was a bubble. And at the peak, one anonymous investor announced a $6.8 billion takeover of a company and the stock price shot up 7X overnight. Only it turned out the anonymous investor was just a guy from Cincinnati who worked for a small advisory firm. The stock crashed back to earth as soon as the market realized the guy wasn't buying anything. But this showed just how frothy the market had become. Even a fake rumor could send stocks soaring. But regulatory shortcomings, the government is not too concerned with leveraged buyouts yet, and no one fully understands how portfolio insurance could somehow backfire. Then the bubble starts deflating. In August of 1987s, the market starts to slide, slowly at first, and they might have kept dipping slowly, but the computers were watching. They started triggering small sell orders, just like they were programmed to. The idea was portfolio insurance would limit your losses by selling little bits along the way down. But no one realized that if everyone starts selling at once, that can become an avalanche very quickly. So the market starts dropping faster and faster and faster. And soon, the market's in free fall, driven by the flaw that everyone overlooked. Sometimes humans aren't rational and the math doesn't always predict them. At one point, there was a New York Stock Exchange specialist who had a crowd standing in front of him with 500,000 sell orders for a single stock, and no one wanted to buy it at any price. And after the smoke cleared, the 1987 crash, also called Black Monday, is still the worst single-day drop in stock market history. All three patterns we've talked about so far collided, investor overconfidence, regulatory shortcomings, but this time, supercharged by a new innovation that the market did not fully understand. But there's still one more pattern, and then we'll look at how these patterns apply today and what investors can do to protect themselves if the market drops. So this next crash is the one that I remember best because I lived through it. In fact, the 2008 housing crash is what got me into investing in the first place. From my perspective, it felt like the system broke overnight. Somehow a bunch of Wall Street bankers 2,000 miles away had basically decimated my neighborhood. A lot of my friends had to move away. And to this day, some neighborhoods still sit empty from the effects. As a kid, trying to understand what caused this crash is what made me realize that sometimes having a understanding of what caused something can make you feel like you have more control over it. At least that's kind of how I felt and why I'm so invested in learning about these things. So this one starts after the dot-com crash when a lot of investors were scared off of volatile tech stocks. They wanted safer investments like housing, and the banks were happy to deliver. So the banks responded by creating mortgage-backed securities and CDOs that were so complex that even they didn't fully understand the risks. But the effect was simple, hand out mortgages to anyone with a pulse and then package them up and sell them off to investors without telling the investors how bad some of those loans were. And that is the fourth pattern we'll be looking at before every market crash, the buildup of debt. And once we look at how that played out in 2008, we'll look at the role that debt plays in the market today. So in the years before 2008, household debt grew rapidly. We had some potential regulatory failures. Clinton had pushed homeownership really hard. The Fed under Bush had kept rates low for half a decade, encouraging cheap borrowing. And no one wants to stop it, not the government, not the banks, not the borrowers who are pushed to buy the flashiest thing, the biggest house they could get a loan for. Debt levels kept on rising. At some point along the way, banks stopped serving the homeowners. Their real customer was the investors buying up these Frankenstein securities built from risky loans that no one had bothered to vet. And it wasn't sustainable. Eventually, this debt would have to be paid back. Even if people at the time thought it must be different this time because housing prices can't drop, right? They're not making any more land. But housing prices did fall. On September 15th, 2008, Lehman Brothers, one of the biggest investment banks in the world, collapsed after running for over 150 years. Unemployment surged past 6% as people lost their jobs. And entire neighborhoods to this day never recovered from the complete collapse of real estate. The subprime mortgage market just unraveled between 2007 and 2010. It dragged down stocks, froze the global economy, and triggered the worst financial crisis since the Great Depression. And if you look back, the patterns were all the same. Investor overconfidence, regulatory failures, innovation no one understood, and the one thing that made it all worse, huge amounts of debt. But now that we've seen the historical patterns, let's see how you can spot a future market crash and what you can do to protect yourself from the next one. So as you've seen, every crash looks a little different, but the patterns are the same. As Mark Twain says, history doesn't repeat itself, but it does often rhyme. So when looking for a crash, ask yourself these questions. Number one, to spot investor overconfidence, are people investing without considering what something is actually worth? Or are they just buying, hoping that they can flip it for a higher price tomorrow? Number two, for regulations, is there a new market popping up that doesn't have any guardrails? Or are we seeing regulations swing in really hard into a market that wasn't prepared for it? For number three, new innovations, is there a new type of investing or asset that people are putting money into without fully understanding? Are people saying it's different this time? And number four, debt, are people buying investments without money they actually have? And is the system leaning too heavily on borrowed cash? I can't answer those questions for you because they change if you're watching the video when it was uploaded or two years from now. But the patterns stay the same. And now you know how to spot them, let's look at what you can do to protect yourself in a market crash. There's four things to do and not do when the market dips. First, don't sell your stocks and move to cash. It's tempting, but crashes often come with high inflation and sitting in cash just makes your money shrink over time. Second, be careful with alternatives like gold. While gold prices do tend to rise when stock prices drop and people selling gold love to show charts like this with gold outperforming stocks over the long haul. When you actually factor in dividends, stocks far outperform gold over the past 100 years, over the past 50 years, and even over the past 30 years. Third, and this might seem counterintuitive, but don't try to time the drop. It's one thing to spot a pattern that a drop may be coming, and it's another to say when it will happen. Long-term investing still outperforms jumping in and out of stocks. And fourth, invest when you have the chance. Crashes are when stocks are on sale. So if you can cut back expenses or increase your income, anything you can do to put more money in stocks now will compound in the future. And look, market crashes can feel scary, and we will eventually see another one. But having a plan and understanding the patterns means the next one doesn't have to bring you down with it. I'm Current Francis, and if you wanna see more of my stuff, YouTube says this video right here. That's the best one to watch next.