Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
When will the next stock market crash happen?
That’s a question I’ve been asked often since I wrote “A History of the United States in Five Crashes – Stock Market Collapses That Defined a Nation.” So far, I have always been able to point out that stock market crashes are happily rare events that only occur when the elements align, and that a crash is unlikely in the near future. Is it still like that?
It is always helpful to examine the factors that contribute to a crash.
The first is a frothy stock market.
It’s no coincidence that the first modern stock market crash, the Panic of 1907, occurred after the largest two-year rally in U.S. history Dow Jones Industrial Average. The benchmark gained 95.9% from 1905 to the end of 1906. The 1929 crash came after the second largest two-year rally of all time, rising 90.1% from 1927 to 1928. More recently, the S&P 500 rose 43.6% that year on August 25, 1987, and 38 trading days later, the biggest crash in history occurred, wiping out all of those gains and more.
The second element for a possible crash is rising interest rates. It was the Federal Reserve that raised short-term interest rates from 1% in May 2004 to 5.25% in September 2006, unsettling the underground economy – while at the same time making stocks less attractive, since buying Treasuries gives you a decent return without risk could achieve. Bills.
The third element is a newfangled financial machinery that gives leverage to the financial system at the most inopportune time. In 1987, there was the misnamed portfolio insurance – which was actually just a plan to sell stocks or stock index futures in ever-increasing numbers when the market fell. In 2008 it was mortgage-backed securities and their metastases such as collateralized debt obligations, collateralized loan obligations and credit default swaps. During the 2010 flash crash, it was naive algorithmic trading and even more naive institutional users who once again failed to think about capacity issues.
The most capricious element is a catalyst. This often has nothing to do with the financial markets. In 1907 it was the San Francisco earthquake. During the Flash Crash, it was the unrest in the Eurozone that almost led to the collapse of the common European currency. Sometimes the trigger is legal or geopolitical.
But for the first time in more than a decade, the conditions for a crash are aligned. That certainly doesn’t mean one is inevitable. The elements are necessary, not sufficient, but they are there.
The S&P 500 has risen 140% since March 2020 and its forward price-to-earnings ratio is now 20.3. This is only the second time since 2001 that the reading has been above 20, FactSet data shows.
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Interest rates have stopped rising, but the 10-year Treasury yield has quadrupled in the last three years. Now expectations of lower interest rates are evaporating; Options traders would call this a synthetic interest rate hike.
There is no telling whether there will be a trigger, but since the trigger for the 1929 crash was legal and the trigger for the 1987 crash was geopolitical, we are prepared.
Finally we come to the apparatus. Historically, the risk posed by the new device triggering a stock market crash has been both opaque and enormous, seasoned with a pinch of leverage. That’s why I’ve always said it’s unlikely to be crypto; There is not enough leverage. But now we are facing a collapse of the private lending market, which is essentially hedge funds acting as banks and making loans.
The private lending market is huge – some estimate it to be as much as $3 trillion in the United States alone. There’s a reason these private borrowers don’t turn to traditional banks – they’re typically riskier than a traditional bank is willing to handle. The International Monetary Fund warned about private lending in April, saying: “The rapid growth of this opaque and highly interconnected segment of the financial system could increase financial vulnerability due to its limited oversight.” That’s one hell of a machine the hedge funds have there: huge, risky , opaque and highly networked. It sounds frighteningly familiar.
How does the prudent investor react? Not by throwing away all your supplies and climbing into a bunker. This is what generally happens after a crash: Investors commit to stocks for a decade or a lifetime and miss out on any subsequent gains. It’s not about speculating on a crash. It is both expensive and impossible to determine a high, and even if you do, you also have to decide on the next low, at a time when fear prevails and greed disappears.
Luckily, the things that work are simple and straightforward. Do you have the right diversification? A traditional 60/40 portfolio still works, and given this year’s price performance, it would be easy to overweight stocks and underweight bonds that benefit from a crash-induced flight to quality.
Are you this year’s highest flyers overweight? Congratulations if so, that means you did well. But the S&P 500 Index is up 12% this year, while the S&P 500 Equal Weight Index is up just 4%. This means that the biggest names and top performers are responsible for the majority of the market’s gains this year.
Finally, stick to your plan. Looking back, all of these crashes seem to be wonderful buying opportunities. Because the American stock market is the place to be, even if it is occasionally painful.
— Scott Nations is President of Nations Indexes, Inc.
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2024-06-10 19:25:28
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