603 | Crash Proof: The Science Of Stock Market Resilience | Brian Feroldi

0:00Hello and welcome to Choose a Vi. Today on the show, we have Brian Feroldi back for another episode. This one was absolutely mind-blowing. We're calling it Crash Proof, The Science of Stock Market Resilience. Brian really goes through questions that a lot of us might ask in the back of our heads, but we never really have an outlet to find out the answers. Ultimately, the question that he's saying is most investors don't understand why markets recover. So we know, if we listen to this show for long enough, you've seen J.L. Collins talk about this. The stock market goes down all the time. It goes down 10 % a year once or twice.

0:34It goes down 30 % once every handful or 10 years, give or take. Seemingly, when you look at the chart, it always recovers. The question is why? This episode unpacks the mechanics of why these recoveries aren't just luck. And the takeaway is it helps you stay invested when times are the bleakest. I think you're really going to enjoy this episode. And with that, welcome to Choose That Five.

1:05Before we get started, I keep this podcast entirely ad-free for two reasons. First, this is a five podcast and I don't want to promote products that I don't want you to buy in the first place. And second, I really like the clean listening experience of a show where you don't have to fast forward ads. To keep it ad-free, all I ask of you as a listener is the next time you open a travel rewards credit card, go to choosefi.com slash cards. And with that, onto the show.

1:33Brian, it is so good to have you back. Thanks for being here. Brad, awesome to be back. Thank you for having me. You did a presentation that was extremely well-received at Economy this year, 2026. The concept is crash proof, the science of stock market resilience. Your contention is a lot of people intuitively understand, whether they mechanically understand or not, but they intuitively understand why the stock market goes down. We can see all sorts of crazy things happening, all these exogenous shocks and COVID and fill in whatever blank you want. But why does the stock market actually recover?

2:08Yes, the general premise is exactly what you set up. About 100 million people in the US alone are essentially betting their financial future on the market going up. And any retirement calculator you have assumes some rate of return, which means that you're betting your financial future on the market continuing to do what it has done historically. Now, if you're like me, you've read a lot of the wonderful books out there that are about the market, and they all show that wonderful image of the market going up and to the right over long periods of time. And all of them say, yes, the market crashes, but the market always recovers.

2:45You just have to have faith that it's going to come back and it always has come back. All of that is true. But what always confused me is that nobody ever explained to me the actual mechanics of what causes the market to recover and what causes the market to kind of come back. And to your point, intuitively, at least to me, it makes sense. So the biggest crashes I've seen in my life were dot-com crash, economy terrible, everything way overinflated. Makes sense the market declined. 2008 financial crisis. People are losing their jobs, housing, prices are collapsing, credit default obligations, all that nonsense.

3:23Makes total sense why the market crashed. COVID, huge, big, negative thing. Makes total sense why the market crashed to me. What made no sense to me was why did the market always bounce back from these big, horrible things? that's what I hope we can help to illuminate for people. Yeah. And also sometimes the speed that it recovered, I'm not sure how much you've dove into that specifically, but I mean, I know with a couple of these more recent ones, COVID, Taras, et cetera, you feel like you blinked and it just came zooming back. Again, that's probably a side tangent, but maybe we'll put a pin in that.

3:58And I suspect that'll be answered by you, but if not, I'd love to ask that later. So yeah, when you said, quote unquote, faith, it recovers. my skin kind of crawled with that because you're right. We'll further the faith thing here and say, we take it as gospel. You look at that chart over a long enough period of time. We could recite it as if we were elementary schoolers and it was just rote learning, right? It's like, okay, yeah, you can zoom in on a certain time period and it might look really scary, but when you zoom out over a hundred plus years, it is up and to the right. But have we ever really dove into why?

4:29So where do we start on this journey? I'm the type of person that I don't take things on, faith, or at least I've always struggled with people saying, trust me, or this is how it works, and not getting a scientific explanation for why that thing happens. And again, many people that are listening to this are betting their financial independence on the market recovering from a crash. And at economy, there were signs that said like, VTSAX and chill. Great saying and totally true, but I'm the type of person that needs more information than that for me to actually feel comfortable. So the goal here is for people by the end of this podcast to understand the three fundamental forces that make the stock market.

5:15And specifically, we're really going to be focusing on the US stock market, the S &P 500, why it always has recovered and in theory should always recover from future crashes. Okay, that makes perfect sense. And now, can I assume, so you wrote the book, Why Does the Stock Market Go Up? So can we zoom out and say that this is not just in relation to crashes, but just general, why does the stock market go up? Is that a fair assumption? We're definitely going to cover that because the same force that causes the market to go up over time is also the same force that causes markets to recover from crashes.

5:55And the good news here is nothing we're about to cover is like super complicated. It's really just understanding the processes that are in place that allow markets to recover. So the hope is the next time the market crashes, and I guarantee you it will crash at some point, that you're not betting the market recovering just on faith or I hope this happens. You actually understand scientifically the forces that cause it to recover. Okay. So three fundamental forces. We're going to get to the first one in a second, but real quick, you said essentially the market is going to crash. For people who are new to stock market investing, whether that's individual stocks or hopefully for most people here, the fundamental basis is broad-based index funds, but they might not know that this is essentially guaranteed, that the stock market is going to crash at some point over their investing lives.

6:46And I know you don't have info in front of you, but I suspect this is something you have memorized. Over a 40 to 50-year investing lifetime, what can someone expect in terms of, hey, the market went down 10 % this year or 20 % or 30 %? Yep. So roughly speaking, on average, the market falls 10 % from its recent high about once every 11 months. So every year, you can expect or you should expect the market from its recent peak will fall about 10%. Every two years on average, that peak to trough is about 15%. And then once every three years on average, it drops 20%. About once a decade, once every 10 years, that fall is 30%.

7:33And then two to three times a century, the fall is 40 % or more. So over a, let's just call it a 50-year investing with that kind of time horizon, you should expect one effectively depression-like crash, about 40 or 50, 10 % drops, about 10 or so 15 % drops, and about 7 or so 20 % drops. And that's what the historic data indicates. And I think that's just a good baseline to have in mind. Yeah, that's really the critical part here is just to understand that this is part of investing in the stock market. Like Brian said, this is happening once every 11 months, a 10 % peak to trough drop. So if you freak out when that happens, that's going to be a tough go.

8:25It's going to be a tough 40 to 50 year investing lifetime. It just is. So Brian, a lot of what we try to do here at Choose a Buy, as you know, is arm people psychologically for these things that are essentially going to happen. I keep coming up with the word preordained, but that's a bit of a stretch, but it's almost a certainty, obviously, that you're going to have a 10 % drop in a given two-year period, three-year period, whatever, especially if on average it's happening once every 11 months. So to everybody listening, this is part of the process. And I think what having a brilliant expert like Brian on to talk about is, okay, look, that's part of the deal, but yet there are these fundamental forces that the stock market always recovers because of them.

9:06And I think, Brian, that is the perfect launching point. So all right, let's start with fundamental force number one. So fundamental force that you need to just drill into your psyche when it comes to the stock market is that stocks follow earnings. Let me say that again. Stocks follow earnings. As go the earnings of a company or an index also goes the price or the market value of that same index. So if a company generates a billion dollars in profit, and then 10 years later, that same company is generating$10 billion in profit, all things held equally, you can assume that that company will have 10 times the market value 10 years later because the profits of that company grew by tenfold.

10:04Conversely, if a company is generating$10 billion in profits, and then 10 years later, it's generating$5 billion in profits, all things held equally, that same company would roughly have half the market value as it did before. So this is a truth when it comes to investing in stocks, stocks follow earnings. Where earnings go, the stock price will eventually follow. Eventually. That's an interesting word. I'm glad you tacked that on there. I'm curious on your theory on how efficient the stock market is and such, because I think a lot of people see oddities, and this is where they find it hard to wrap their mind around.

10:45Is it really tethered to reality? Is it really tethered to earnings or is it based on meme stocks or these random icons that they seem to love? Eventually is the critical word there. And how do you think through short term versus eventually when it comes to stock price following earnings? The best analogy that I've ever heard with thinking through this is a man walking a dog on a leash that's made out of elastic band. The man represents the profits of, let's just call it the economy, and the dog represents the price of the stock market. So the man is walking up a very slowly gradual hill. Profits of all corporations are gradually growing over time, but the dog is reacting wildly to the environment around him.

11:39Sometimes the dog is really excited, jumps way ahead of the man, trying to go up to sniff things and smell things, but the dog is attached to the man by this leash. Eventually, something scary comes along and the dog darts way behind the man and the man is now leading the dog. That is how you have to think of stock earnings versus stock prices. The two of them can be wildly detached from each other over the short term, but over the long term, you need to watch where the man goes, not where the dog goes. The problem is the dog is so much more interesting than the man. Everybody in the news is focused on what is the dog looking at?

12:23What caught the dog's attention? Is the dog really excited or not? That is the price that gets quoted in the news that gets thrown at you all the time. What that is, is just a dog reacting to its immediate environment. And I would even protest, most people that invest in the stock market don't even know the man exists. I would challenge everybody, as soon as you have a free moment, if you're driving or ever, Google these words, S &P 500 earnings, and pull up a chart that shows you the earnings, aka the profits of the S &P 500 over the last 100 years. I bet this is a chart that you've never seen before.

13:06That chart shows you the man. What is happening to the actual profits of the S &P 500? Spoiler alert, it's a chart that is squiggly but goes up and to the right. And that is the thing that you need to truly pay attention to if you're an investor. What are the profits of the S &P 500? Then overlay that same chart with the price. And while they are wildly detached from each other in the short term. In the long term, there's essentially a 100 % correlation between those two things. I love that. The dog, the leash, the man, that's something people can really grab hold of. It's keep your eye on the man.

13:47That is really interesting. You can hear me think through it as we're talking here because like you said, it's sexy because you see that number. People talk about it. It's on cable news. And also, frankly, that's the number that shows up multiplied by the number of shares you have when you log into your brokerage account. That is a visceral number because, oh, my net worth went up. Oh, my net worth went down as opposed to this earnings, which sure, that sounds good in theory. But when it's detached from the near term, hey, earnings went up, but oh, damn, the stock price went down. That doesn't make any sense is what people think.

14:24So how could it be as inextricably linked as you're saying? And I'm not trying to harp on this, but eventually is the part. And I know you do in-depth analysis of stocks. And also, I know you're now doing this with the help of AI, which I heard you on. Paula's Afford Anything, which is really cool. How do you think about eventually? What type of time frame is that for you, Brian, the individual stock investor? It depends on if you're talking about investing in an individual stock or if you're talking about investing in index. my personal strategy is my retirement funds, my 401k, my Roth IRA, all that kind of stuff.

14:57It's just indexed. Dollar cost averaging. I look at that maybe once a year. I truly don't care about the price of the net worth of those assets because I know internally I'm betting on the man and the man will eventually do his thing. And if I'm correct about the man, the price will totally take care of itself over the long term, which I think is a very psychologically healthy way for most people to invest. With individual companies, it's a little bit different because the man moves at a way faster speed than he does for the economy in general. And the leash between the man and the dog can be wildly longer and it can snap back way, way shorter.

15:38So generally speaking, if I'm buying an index that I believe in for the long term, I just set it up on autopilot once and check it on at once a year. If I'm buying an individual company, it requires more frequent check-ins. But as a general statement, I like to give companies at least three years from when I purchased them before I would make another decision about I was right or I was wrong about that company. Okay. So three years. I like that. Again, not going on faith. I think that's going to be a through line here. So my question for you, you just talked about all of these retirement accounts, long-term accounts that are in broad-based index funds, probably S &P 500 or total stock market.

16:16So I guess my question to you is, are there possibly periods where the price of the market, the price of stocks, let's say, is wildly outpacing earnings? And you might say, as Brian Farrell, the intelligent investor, look at it and say, hey, I know this is on autopilot, but something isn't right here. Maybe it's time for me to make a shift. Again, it's like the fundamental underpinning of FI is we dollar-cross average, all these things, right? But again, we're not taking it on faith here. How would you think through that? Again, it gets into active investing, and that's another thing that maybe we want to shy away from.

16:56But realistically, there must be periods where stock prices are far outpacing earnings for some reason over that short term. Do you ever think about changing your strategy in these retirement accounts? The answer to your question is yes, there are absolutely periods when those two things become fundamentally detached from each other. The media shorthand for those periods are bubble, right? All the bubble means is that the price has become wildly detached from the fundamentals of that same asset. At the end of 1999, there's no doubt looking backwards with the benefit of hindsight that we were in a internet stock bubble, right?

17:35Companies weren't even reporting earnings. They were reporting eyeballs or users. And that's what their stocks were actually trading against. There was no man. There was a hope to potentially preserve a man. Right, exactly. So the leash was attached to nothing. Absolutely nothing. The leash kept going forward and forward and forward. Yeah, there are periods in time like that. If you look at the market as a whole, there are some indicators that you can use to figure out are the prices detached from fundamentals. There's things like the cyclically adjusted PE ratio, also called the CAPE ratio. You can look at the PE ratio of the market in general.

18:13You can look at the Warren Buffett indicator, which measures the gross domestic product of a country to the market value of the country. So there are things that you can look at kind of at the macro level. But to answer your question, does that change what I think is the best advice for what you should do? The answer there is no. I don't change anything about my contributions to my retirement accounts when even if I thought prices were high. So that part of my portfolio is on autopilot. And I think that that's the correct thing for people to do. Don't stop contributing to your 401k. Don't stop contributing to your whatever system you have in place that's on BTSAX and chill.

18:50I wouldn't touch anything about that. I do make more tactical decisions with the individual stock portion of my portfolio. I'm not trying to time the price of those positions. I'm trying to time the valuation of those positions. And I'm trying to invest when the leash is a favorable distance between the dog and the man. So I hope that that answers the question as to what I do. Brian, one last thing on this. I'm kind of playing devil's advocate, as you can tell, because this is my strategy as well. But for somebody out there who's saying, all right, look, maybe there are some times where there's a bubble and it seems that historical earnings and prices are out of whack.

19:29And maybe they're only a couple of years from FI. I think it's easy for you and I in our forties to say, all right, look, there's a real likelihood for our retirement accounts. We're not going to need them for 20, 30, or maybe more years, especially if we have a significant amount in our taxable brokerages. So over 20, 30, 40 plus years, we're both pretty happy that this is going to go up into the right. But what if the timeframe was different? What if you were 58 and you were relying on that money at 59 and a half? Again, you, Brian, and you saw a bubble forming. And I'm not asking you to tell us precisely, tactically what you do, but would you consider, or is this still like a, hey, this is the best strategy.

20:08I've done all the research that satisfies me. How would you think about that particular instance? What you're effectively asking is portfolio strategy and allocation decision-making frameworks. And this is where I would call on people that are smarter than me about this topic, like Frank Vasquez, for example. What is the proper asset allocation for you 10 years from retirement, five years from retirement in, using the word retirement, financial independence and post that? How much of a cash position should you have? Should you focus more on fixed income, like bonds and stuff like that? Should you have a bond ladder that pays for your lifestyle?

20:41I'm a fan of all that kind of thinking. It just depends on how complicated you want to get to it. For me personally, once I am truly dependent on my portfolio, I will absolutely dial back the risk profile, generate more income for myself, have a big cash cushion to pay for a year plus of expenses. That's absolutely something that I'm going to do and to consider. So to me, that's almost a separate question about what is the proper asset allocation. If you are nearing retirement and you think that prices are elevated, there's all kinds of things that you can do to protect yourself from higher valuations.

21:17Yeah, I agree. Frank Vasquez, he's someone who I'm going to get on to talk about that very specifically. Before we move on to Fundamental Force 2, is there anything else that we should talk about with Force 1? Are there examples? Can we talk about specifically how S &P 500 earnings have grown consistently? Anything else you want to dive into before we move on? Yeah, just one thing to think in mind. I think analogies and real-world examples are just so helpful. Anybody here that watches Shark Tank knows this point kind of intuitively. If somebody walks into the Shark Tank with an idea and the sharks are like, how much revenue are you doing?

21:50And they're like, zero. What is the valuation that the sharks are going to assign to that company? They're going to do a very, very low valuation because the sharks know that the risk here is enormous. This hasn't been proven out in the world at all. It's just an idea at this point. So they're going to want a very low valuation. They're going to want to give a little bit of money and get a huge equity stake if they decide to invest. Conversely, if somebody walks into the shark tank and they say, how much revenue did you do? They said, we did$10 million in revenue in the last year, and we did$2 million in profit.

22:19The sharks are going to give that company a way bigger valuation, and they're going to be much more comfortable giving that company money and taking a smaller ownership stake because that model is proven out and the company may have lots of sales or even best case scenario, lots of profits that they need. So you've seen this valuation thing and the fact that stocks follow earnings kind of play out in Shark Tank. Companies that come in with no sales and no profits, low valuation, high sales, high earnings, big valuation. Same exact concept applies to stocks and the stock market. Let's move on to force number two here, Brian.

22:58Okay. So now that we accept, and I really hope that you accept force number one, stocks follow earnings, the answer to the question, why does the stock market recover is very simply earnings, profits always recover from crashes. The reason that this happens is not a mystery. It is not magic. There is a predictable process that happens during any economic recession or any economic downturn that causes profits first to plunge and then to recover and bounce back. And as long as earnings bounce back, remember stocks follow earnings, so too will the price of the index. So again, if you pull up a chart showing the S &P 500 earnings over the last 100 years, it's a squiggly line.

23:52And every time the line crashes, so every time profits crash, they almost immediately bounce back and return to their former highs and then eclipse their former highs. So that's what I hope to talk about with force number two. Why after they decline, do they bounce back? If you understand why they bounce back, you will understand why the market bounces back. Okay. Well, I definitely am quite, quite curious on this because yeah, again, not taking things on faith and also things that aren't intuitive, right? Like if there's some outside shock that actually made a material difference in the world, it's not 100 % intuitive that earnings are always going to recover.

24:32And that's why we're going to get into the forces here. So I'm just going to let you run with this. Sure. I want you to think of a economic recession or depression, kind of like a forest fire. Like think of it like an economic forest fire. So a spark gets lit by something bad going on and all this brush that's kind of out there gets burned away. So that's the mental model I want you to have as we go through this. Okay. So what happens as a fire is raging in the economy? Well, step one is that businesses lose revenue. Demand for their products and services goes down. So how do companies react when demand for their products and services go down?

25:16Well, they have a fire alarm go off. The management team jumps in and says, oh crap, I do not have demand. We're not selling our products anymore. We need to tighten our belt. We need to cut hourly workers for shifts. We need to lay off people. We need to get our financial house in order. It's an extremely painful period for the company, for the employees that are affected, but this is understandable. Companies must lower their costs to align the business expenses with the new levels of demand that they're seeing. So they have to get more lean, if you will. And this is why when recessions first start, you see headline after headline, thousands of jobs cut.

26:01Microsoft cuts jobs. This company cuts job and the unemployment rate kind of skyrockets. This is the worst part of the process, no doubt. It's painful for everybody, but it has to be done because companies need to right-size their expenses to their new levels of revenue. All right. That makes sense. I'm thinking in terms of what are ramifications. Again, it's like this is a process and I know you're going to walk us through this because I'm thinking, okay, obviously high unemployment, not wonderful. That doesn't automatically suggest that we're going to have this wonderful unicorns and rainbows recovery and earnings are going to come back, but this isn't your first rodeo, right?