Will the U.S. stock market crash this month? Why an October surprise can't be ruled out.

By Mark Hulbert

Huge one-day plunges are rare, but the probability is not zero - particularly in October

October is a spooky month for U.S. stocks, with two of the worst market crashes occurring in October of 1929 and 1987.

While the chances of an October 2024 crash are low, they're not zero. The best lesson we can draw from past Octobers and other major stock-market disruptions is that large one-day market plunges are an inevitable part of investing, and investors should prepare accordingly.

That's easier said than done because crashes are so rare. It's possible that none of us in our lifetimes will experience a crash as bad as the one in 1987, when the Dow Jones Industrial Average DJIA shed 22.6% in a single session, or in 1929, when the Dow in a single day fell 12.8%. Or we could suffer through several.

This is where so-called black-swan strategies can be valuable. Black swans are largely known on Wall Street because of mathematician Nassim Taleb's 2007 book, "The Black Swan: The Impact of the Highly Improbable." Black-swan events are sudden, awful, unpredictable and extremely rare; market crashes definitely qualify.

A brief history of crashes

Before discussing black swan strategies, it's important to review the history of financial market crashes. Two decades ago, researchers derived a formula that tells us how many daily crashes we should expect over long periods of time. It was published in the May 2003 issue of the scientific journal Nature, and readers interested in the specific formula should consult the original study. The formula assumes that crash frequency follows a "power-law" distribution, as opposed to the more common "bell-curve" distribution.

The researchers' formula has held up remarkably well in real-time. For example, the model's prediction in May 2003 would have been that over the next 21.4 years - until now, in other words - there would be one trading session in which the market would lose as much as it did during the October 1929 crash. And in fact, there's been one such day: March 16, 2020, when the Dow lost 12.9%.)

The chart below summarizes the model's predictions over a 100-year period and the actual results for the Dow over the past century. The model's record is impressive.

Why are crashes inevitable? Xavier Gabaix, a finance professor at Harvard University and the study's lead author, said in an interview it's because large institutional investors on occasion want collectively to get out of equities in a big hurry - and regulators are powerless to stop them when they do. These investors have many alternative ways of reducing their equity exposure, from derivatives to markets outside the U.S. Trading halts will therefore be largely ineffective.

What's the matter with October?

The next question that many have is whether there's anything about October that makes markets in that month especially vulnerable to crashing. Unfortunately, the data are inconclusive, in large part because crashes are so rare. Because of that, we have insufficient data to reach robust statistical conclusions.

For example, of the four trading sessions over the past century in which the Dow fell by more than 10%, three occurred in October. This might seem significant, since October's share of the total is 75% - far higher than the 8.3% (100/12) you'd expect if October were no more likely than any month to experience a crash. But we can't draw any meaningful conclusions from a sample of just four.

That said, October does appear to be the most volatile month for the stock market, as I discussed recently. Gabaix said in an email that while he hasn't studied the relationship between crashes and volatility, he would guess that "crashes are more likely when volatility is high." To this extent, therefore, a case can be made that there is a higher crash risk in October.

Preparing for a black swan

Nevertheless, because crashes are so rare, even in October, traditional approaches to reducing risk are not helpful, according to Taleb. Trying to protect your portfolio from "average" risks might make sense if daily market changes followed a bell curve distribution. But not when the left-hand tail is "fat" - larger than expected than in a bell curve distribution. And that's the case in the stock market.

To protect yourself from fat left-hand tails, or black swans, Taleb recommends what he calls a "barbell" strategy: "Your strategy is to be as hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative." An example would be an all-stock portfolio that allocates a small percentage to long-dated deep out-of-the-money index put options. Most of the time those options will expire worthless, but once in a blue moon, they will pay off in a big way.

Consider the performance of Universa Investments, an investment firm for which Taleb is an adviser. The financial press reported at the time of the March 2000 market crash that its strategies' year-to-date returns exceeded 4,000%.

Though the firm doesn't reveal its specific strategies, Michael Edesess (an economist and mathematician who is an adjunct professor at the Hong Kong University of Science and Technology), created an actively run portfolio that matched both Universa Investments' long-term performance as well as its spectacular return in 2020. Edesess's portfolio was 96.67% invested in the S&P 500 SPX and 3.33% in puts.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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