If a Stock Market Crash Is Coming, History Says Investors Who Do This Will Turn a Big Profit

Year to date, the broad-based S&P 500 (SNPINDEX: ^GSPC) has advanced 13%, and the technology-heavy Nasdaq Composite (NASDAQINDEX: ^IXIC) has added 15%. But the stock market may lose its momentum in the months ahead if the Federal Reserve raises interest rates, and the downturn could be severe (perhaps even a market crash) because midterm elections tend to incite volatility.

On the bright side, history provides a simple blueprint for success. In the event of a stock market crash, the smartest move investors can make is to buy the dip, particularly after the S&P 500 and Nasdaq Composite have closed in correction territory. Here are the important details.

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Interest rate increases and midterm elections could cause a stock market correction

Oil prices have increased substantially this year because the Iran conflict has disrupted a key supply route in the Persian Gulf. As of Aug. 7, WTI crude futures (the U.S. benchmark) have risen nearly 40% since January, and the upward pressure on energy prices has caused inflation to reaccelerate.

The Personal Consumption Expenditure (PCE) price index, the Federal Reserve's preferred measure of inflation, rose 4.1% in May. That was the highest reading in five years. PCE inflation has cooled slightly since then, but projections from the Cleveland Fed show the metric trending toward 3.8% in August. That is still much higher than the central bank's 2% target.

The most worrisome part is that PCE inflation has now exceeded the Fed's target for more than five years, and policymakers are starting to lose patience. The Federal Open Market Committee (FOMC), the Fed's rate-setting division, updated its economic projections in June. Half of participating Fed governors and presidents now expect at least one quarter-point rate increase in 2026. By comparison, zero officials anticipated rate increases earlier this year.

The next interest rate increase will signal the beginning of a new tightening cycle, and history says it could trigger a stock market correction. Since 1997, the FOMC has initiated five other tightening cycles, and the S&P 500 and Nasdaq Composite fell by an average of 10% and 12%, respectively, at some point in the next three months.

However, the stock market could drop more sharply than those figures suggest this year because of the midterms. The president's party typically loses seats in Congress at midterm elections, which creates policy uncertainty. Some investors navigate that uncertainty by selling stocks. Since 1950, the S&P 500 has fallen by an average of 18% at some point during midterm election years, per Carson Research.

The S&P 500 and Nasdaq Composite have historically rebounded quickly from stock market corrections

The S&P 500 has suffered 10 market corrections since the Great Recession, two of which turned into bear markets. During the same period, the Nasdaq Composite has suffered 14 market corrections, four of which became bear markets. But both indexes have always recovered, meaning a buy-the-dip strategy has always made money.

The statements below pertain to market corrections since the Great Recession:

• After the S&P 500's first close in correction territory (i.e., the first close 10% below its high), the index returned an average of 18% during the next year and 38% over the next two years.
• After the Nasdaq Composite's first close in market correction territory, the index returned an average of 23% in the next year and 41% during the next two years.

The one thing investors should not do is attempt to time the market by selling stocks with the intention of repurchasing them at some point the future. Legendary fund manager Peter Lynch once warned, "Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in corrections themselves."

The smartest move investors can make? Buy the dip (after the S&P 500 and Nasdaq close in correction territory)

Stock market corrections are unavoidable and unpredictable. We may see one this year if the Federal Reserve starts a new rate-incresase cycle, and the decline could be particularly steep (perhaps even a market crash) because midterm elections tend to coincide with material losses in the stock market.

Regardless, there is a simple lesson: The smartest decision investors can make if the stock market crashes is to buy the dip. In particular, investors should buy an S&P 500 index fund or Nasdaq Composite index fund after the benchmark index has closed in correction territory. Historically, investors who followed that blueprint turned sizable profits during the next one and two years.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.