The Relationship Between Indices and Market Crashes: Validating a Thesis

IntroductionUnderstanding market dynamics before, during, and after a crash is crucial for navigating financial markets effectively. A well-founded thesis suggests that the performance of major indices—Russell 2000 (RUT), Dow Jones Industrial Average (DOW), NASDAQ (NDQ), and S&P 500 (SPX)—varies significantly in these phases, offering key insights for investors. The thesis posits the following:

1. During bull markets, NASDAQ and, to a lesser extent, S&P 500, outperform Russell 2000 and Dow Jones due to their growth orientation.

2. In the pre-crash period, Russell 2000 and Dow Jones outperform NASDAQ and S&P 500, reflecting a rotation toward value and cyclical stocks.

3. During market crashes, all indices decline similarly in magnitude.

4. In recovery phases, NASDAQ and S&P 500 again take the lead in performance due to their growth-heavy nature.

This article examines the thesis using historical data and graphical insights.

Analysis and Results

1. Bull Markets

   
   

   Historical data confirms that during sustained upward trends, NASDAQ consistently outperforms other indices in terms of daily percentage gains, followed by S&P 500. This outperformance is driven by the technology and growth sectors that dominate the NASDAQ, which tend to thrive in optimistic market conditions.

   
   

2. Pre-Crash Periods

   
   

   The 30 days preceding a crash reveal an interesting trend:

   • Russell 2000 and Dow Jones often outperform NASDAQ and S&P 500 in cumulative returns, as investors pivot toward more defensive or cyclical sectors.

   • NASDAQ frequently underperforms, reflecting its sensitivity to volatility and rising uncertainty.

The July-August 2024 crash further highlights these dynamics:

2. The S&P 500 saw its worst July in a decade, declining by 1%, after a strong first half of the year.

3. On August 5, the Dow Jones Industrial Average dropped over 1,000 points before partially recovering.

4. The Volatility Index (VIX), or "fear gauge," spiked significantly as global equities sold off.

5. The Russell 2000 experienced milder pre-crash losses compared to NASDAQ and S&P 500, supporting the thesis of its relative resilience in pre-crash periods.

The graph below illustrates cumulative performance during pre-crash periods for several historical market crashes:

This graph clearly shows that Russell 2000 and Dow Jones tend to experience smaller cumulative losses compared to NASDAQ and S&P 500 in pre-crash periods, validating the thesis.

3. Crashes

   
   

   During market crashes, the data shows that all indices decline by similar magnitudes. The July-August 2024 crash exemplifies this, with synchronized drops across major indices due to fears over the U.S. economy, rising interest rates, and rapid unwinding of leveraged positions.

   
   

4. Recovery Phases

   
   

   In the recovery phase, NASDAQ and S&P 500 lead in terms of daily percentage gains, reflecting their growth orientation and the rapid rebound of tech-heavy and large-cap stocks. Russell 2000 and Dow Jones, while recovering, typically lag behind.

Implications for Investors

These findings offer practical guidance:

• In bull markets, overweighting growth-focused indices like NASDAQ and S&P 500 could maximize returns.

• As market conditions deteriorate, shifting toward Russell 2000 and Dow Jones may offer relative resilience in pre-crash periods.

• During crashes, diversification across indices is crucial, as all experience significant declines.

• In recoveries, emphasizing growth-heavy indices like NASDAQ can capitalize on rapid rebounds.

This analysis validates the thesis that the performance of major indices varies predictably across market phases. By adding insights from the July-August 2024 crash, the evidence strengthens the thesis and highlights actionable trends for portfolio management.