History suggests a stock market crash is likely: 5 worrying data points

Whether you realize it or not, investors have witnessed history for the past 18 months. They went through the fastest decline of at least 30% in benchmark history S&P 500 (SNPINDEX: ^ GSPC) and experienced the fiercest rebound rally on record. It took the S&P 500 less than 17 months to more than double from its bear market low.

But if history has something to say about the stock market in the short term, trouble could be brewing. Five data points all suggest that a stock market crash may be on the horizon. Keep in mind that while these data points can be of concern, we can never determine when a crash will occur, how long it will last, or how steep the decline will be.

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1. Crashes and fixes happen frequently

The first thing to note is simply how often stock market crashes and corrections occur in the S&P 500. According to data provided by market analysis firm Yardeni Research, the benchmark has suffered 38 declines of at least 10% since the early 1950s. This results in a crash or correction, on average, every 1.87 years. In some context, we are over 1.4 years from the bottom of the coronavirus crash bear market and didn’t even have a 5% correction in nine months last weekend.

Admittedly, the stock market does not respect the averages. If it did, everyone would just trade based on averages and we would all be sipping mai tai on a secluded beach right now. However, these averages provide clues to the frequency of declines that long-term investors should keep in mind.

Additionally, it’s important to understand that the vast majority of crashes and fixes don’t last very long, even though they do happen quite frequently. The average duration of the 38 aforementioned declines since 1950 is 188 calendar days, or about six months. It has gotten even shorter since computers became mainstream on Wall Street in the mid-1980s, with an average remediation time of 155 days (five months).

A professional broker on the phone, with several stock charts displayed on computer screens.

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2. Bouncing back from a bear market bottom is never easy

The next point of concern examines how the S&P 500 reacts after finding a bearish market bottom.

As noted, the index took less than 17 months to double in value from its March 2020 low. But if we look at how the S&P 500 reacted after the previous eight bear market lows, dating back to 1960, you would see a very different story.

After each of the previous eight bear market lows, there has been at least one double-digit percentage drop in three years. In five of the eight of these bear market rebounds, there have been two double-digit declines. Coming back from anything that has driven the broad market 20% (or more) is a time consuming process. This has simply never been the higher straight line that we have been blessed with since March 23, 2020.

On the other hand, long-term investors can take comfort in the fact that every crash or correction in history has finally been put in the rearview mirror by a bullish market rally. While the market can be bumpy at times, it strongly promotes long-term optimism.

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3. The valuation of the S&P 500 poses a problem

One of the biggest telling warnings for the stock market was the S&P 500’s Shiller price-to-earnings ratio. This is a metric that examines inflation-adjusted gains over the past 10 years.

In some context, the P / E of the S&P 500 Shiller closed last week at 38.58, a nearly two-decade high. It’s also well over double Shiller’s average P / E of 16.84, going back 151 years.

But it’s not the distance above its historic P / E Shiller average that is of concern. Rather, this is how the S&P 500 has reacted to each of the previous times it has crossed and maintained a P / E of 30. In each of the previous four cases where the Shiller P / E of the S&P 500 has crossed and maintained 30 , the index lost anywhere. from 20 to 89% of its value. While the 89% lost during the Great Depression would be next to impossible today thanks to the ongoing intervention of the Federal Reserve and Capitol Hill, the main takeaway is that a 20% drop has been the expectation. previous minimum when valuations are extended upward.

However, it should be noted that internet-induced democratization of investing has dramatically increased P / E multiples over the past quarter century. With information accessible at the click of a button, rumors no longer weigh down valuations as they once did. Thus, higher P / E Shiller values ​​could become the norm.

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4. Inflation could be a worrying sign

A fourth cause for concern is the rapid rise in inflation: that is, the rise in the prices of goods and services.

Earlier this month, the US Bureau of Labor Statistics released inflation data for July. This report showed that the consumer price index for all urban consumers rose 5.2% in the past 12 months. This was down very slightly from the 5.4% increase in June, which was an over 12-year high. When the price of goods and services paid by individuals and businesses increases, it tends to weigh on economic growth (i.e. individuals / businesses cannot buy as much with the same amount of money ).

What is worrying is how closely linked periods of high inflation are to stock market hiccups. For example, the last time the inflation rate exceeded 5%, the United States was sinking into the Great Recession. Looking a little further, the inflation rate was approaching 4% before the dot-com bubble burst. Finally, the inflation rate accelerated before the 1990-1991 recession.

Understand, however, that correlation does not imply causation. Just because inflation has accelerated doesn’t mean stocks will go down. However, lower purchasing power coupled with higher inflation cannot be ignored as negative potential for the US economy and equities.

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5. Investors are borrowing, and that’s usually bad news

The last data point that should be of concern is margin debt. Margin describes the amount of money investors borrow (and pay interest) to buy or bet against securities.

While not a perfect correlation, rising margin debt has often been bad news for the stock market. For example, margin debt increased about six-fold between the trough of the 1987 Black Monday crash and the start of the dot-com recession. Since bottoming out of the bear market in March 2020, margin debt has nearly doubled from just over $ 400 billion to $ 844.3 billion, according to data from the Financial Industry Regulatory Authority, via Yardeni Research.

Additionally, the last two times margin debt jumped at least 60% in any given year were just before the dot-com recession and the Great Recession. While margin debt actually declined in July, it had risen by 70% since the start of the year just a few months earlier.

The problem with margin is that lenders (i.e. brokers) can require additional capital to be added to an account, or assets to be sold, to maintain minimum liquidity requirements. If a stock quickly takes the wrong direction in the short term, forced sell-offs via margin calls can cause a cascading stock market crash.

As I noted, using the margin does not guarantee that a crash will occur. But there are enough warning signs here for investors to be aware of the potential for a crash on the horizon.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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About Robert Valdivia

Robert Valdivia

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