You may not like what I’m about to say, but it’s an undisputed truth backed by data: Stock market crashes and corrections are happening all the time.
Since the early 1950s is the benchmark S&P 500 (SNPINDEX: ^ GSPC) have has undergone 38 separate crashes or fixes which has led to a decrease of at least 10%. This acts as a correction that hits the S&P 500 on average every 1.87 years.
However, the stock market does not adhere to averages, and it often behaves unpredictably, at least in the short term. We never know in advance exactly when a stock market crash or correction will occur, how long it will last, or how steep the fall will be.
But treat me for a moment, because a confluence of four near-term factors coming together that could encourage a stock market crash very soon.
Valuations are stretched to two decades heights
Perhaps the most front-and-center concern for the market is the valuation of stocks that have fallen in nothing less than the nosebleed area.
The Shiller S&P 500 price / earnings (P / E) – a P / E ratio based on average inflation-adjusted earnings from the previous 10 years – closed at 35.66 on February 35. It marks the highest level since the dot-com bubble almost two decades ago. It is also more than double the average Shiller P / E ratio (16.78) over the last 150 years.
On the one hand, there are sustainable reasons why stocks are more expensive than they have historically been. Eg. Are lending rates at or near record lows, which has made lending very advantageous for companies with branded goods and growth. In addition, access to the Internet since the mid-1990s has helped create a level playing field for retail investors and Wall Street. The free flow of information has helped dampen rumors and enabled investors to value stocks more comfortably at a historic premium.
On the other hand, history has not proven to be good for a Shiller P / E ratio that is north of 30. In the previous four cases where a bullmarket rally pushed Shiller P / E sustainably above 30, the S&P 500 was lost anywhere from 20% to 89% of its value. While history does not guarantee that it will happen again, it is quite crucial that valuations that are so high are not well tolerated for long periods of time.
Emotions is a kettle that can explode at any moment
In the long run, growth in operating earnings is what drives share valuations higher. But in the short term, a number of news events and emotions tend to prevail. This has been particularly evident in recent weeks with Reddit retail investors causing dozens of stocks to swing wild.
Without getting too far into the weeds, retail investors on Reddit’s WallStreetBets chat room initially chose to band together and buy stocks and call options on heavily short-selling stocks (ie stocks where hedge funds and institutional investors bet a step lower). By flooding in stocks like GameStop, retail investors could create one short clamp that sent GameStop and a handful of other select stocks into the stratosphere.
But the thing about emotion-based investing is that the mood (1) changes for a penny and (2) often causes investors’ convictions to shift up and down. The S&P 500 probably did not deserve 34% shellacking in less than five weeks in February-March 2020. Likewise, it probably does not deserve a P / E of almost 36 given that the US economy has not even fully recovered from coronavirus disease 2019 (COVID -19) recession.
It would not take much for emotion-driven momentum traders to send the stock market in a downward spiral.
Coronavirus variants threaten to halt progress
No discussion of stock market crashes would be complete without mentioning the role the COVID-19 pandemic could still play.
In Wall Street’s mindset, getting from the start of the pandemic to the end means drawing a straight line from point A to B. But the reality is that getting from A to B will involve countless detours. The United States must:
- Ensure enough vaccines to cover the adult population.
- Make sure enough of the population chooses to vaccinate to achieve herd immunity.
- Distribute the vaccine effectively to prevent the doses from being wasted.
- Administer the doses quickly to prevent coronavirus mutations and variants from minimizing the effect of existing vaccines.
To expect everything to go smoothly is foolish (with a small ‘f’). What we know about COVID-19 and how we respond to it from a social and economic perspective is evolving from month to month. It is not out of the question that a COVID-19 variant is throwing Wall Street and the scientific community for a loop, ultimately causing panic to emotionally driven investors.
4. A marked decrease in buybacks is about becoming easily visible
Finally a significant cuts in stock buyback programs over the last six to nine months could begin to weigh stocks.
In the two years leading up to the COVID-19 pandemic, S&P 500 buyback activity became a full-time high. Following the adoption of the Tax Relief and Jobs Act in December 2017, maximum corporate tax rates were cut to a low eight-decade level of 21%, enabling companies to return more capital to investors.
During the height period of the coronavirus recession is bank shares and a host of branded companies announced that they would reduce or completely store their repurchase activity to save money. According to market analysis firm Yardeni Research, S&P 500 companies went between $ 750 billion and $ 850 billion. In annual repurchases through large parts of 2018 and 2019. From the third quarter of 2020, S&P 500 repurchases amounted to only DKK 407 billion. $.
Share buybacks have in recent years played a remarkable role in creating earnings growth – ie. fewer outstanding shares have led to higher earnings per share. Shares. Without this buyback push, earnings growth could be significantly slower than expected in 2021 and ultimately precision stocks.
Whatever happens to the short-term, long-term investors are undefeated if they stay the course. Nevertheless, it may be a smart idea to have some cash ready if a stock market crash is around the corner.
This article represents the author’s opinion, that may disagree with the “official” recommendation position for a Motley Fool premium advisory service. We are motley! Questioning an investment dissertation – even one of our own – helps all of us think critically about investing and make decisions that help us become smarter, happier and richer.
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