Traders work on the trading floor of the New York Stock Exchange.
Brendan McDermid | Reuters
When will the next stock market crash occur?
This is a question I’ve been asked frequently since I wrote A History of America’s Five Crashes—The Stock Market Crashes That Defined a Country. So far, I have been able to suggest that stock market crashes are reassuringly rare events that only occur when factors align, and that a crash is unlikely in the near future. Is this still the case? Come!
It’s always helpful to examine the factors that caused the crash. The first is the stock market bubble.
It was no coincidence that the first modern stock market crash, the Panic of 1907, occurred after the largest two-year rally in history. Dow Jones Industrial Average. From 1905 to the end of 1906, the benchmark index rose 95.9%. S&P 500 Index On August 25, 1987, the stock was up 43.6% for the year, and 38 trading days later the largest crash in history occurred, erasing all gains.
The second factor in a potential collapse is rising interest rates. It was the Fed that raised short-term interest rates from 1% in May 2004 to 5.25% in September 2006, disrupting the shadow economy and making stocks less attractive because you could buy Treasury bills risk-free. Get substantial returns.
The third element is some novel financial device that injects leverage into the financial system at the worst possible times. In 1987, this was portfolio insurance in name only—it was really just a plan to sell large amounts of stocks or stock index futures as the market fell. In 2008, what emerged were mortgage-backed securities and their derivatives, such as collateralized debt obligations, collateralized loan obligations and credit default swaps. During the Flash Crash of 2010, it was naive algorithmic traders and even more naive institutional users who again failed to consider capacity issues.
The most capricious element is the catalyst. This generally has nothing to do with financial markets. In 1907, there was an earthquake in San Francisco. During the flash crash, turmoil in the eurozone nearly led to the collapse of the European common currency. Sometimes the catalyst is legal or geopolitical.
But for the first time in more than a decade, the factors leading to the collapse are aligning. That certainly doesn’t mean it’s inevitable. These elements are necessary but not sufficient, but they are there.
The S&P 500 has gained 140% since March 2020, and its forward price-to-earnings ratio is 20.3. This is only the second time since 2001 that it has topped 20, according to FactSet data.
Interest rates have stopped climbing, but the yield on the 10-year Treasury note has quadrupled in the past three years. Now, expectations of lower interest rates are fading. Options traders call this a synthetic rate hike.
It’s unclear if there will be a catalyst, but since the catalyst for the 1929 crash was legal and the catalyst for the 1987 crash was geopolitical, we are ready.
Finally, we come to the device. Historically, the risks posed by this new device for triggering stock market crashes are opaque, massive, and highly leveraged. That’s why I always say it’s unlikely to be crypto; there’s not enough leverage. But now we have the collapse of the private credit market, which was essentially hedge funds acting as banks and making loans.
The private credit market is huge – some estimate it reaches $3 trillion in the United States alone. There’s a reason these private borrowers don’t turn to traditional banks—their risk is typically higher than traditional banks want to handle. International Monetary Fund in april A warning on private credit: “With limited regulation, the rapid growth of this opaque and highly interconnected part of the financial system could exacerbate financial vulnerabilities.” It’s a curious device for hedge funds: huge, hugely risky , opaque and highly relational. It sounded eerily familiar.
So how should prudent investors respond? Not dumping all your stocks and crawling into cover. This is often what happens after a crash, with investors swearing off stocks for a decade or a lifetime and missing out on all subsequent gains. This is not achieved by guessing the collapse. Picking a top is expensive and impossible, and even if you do, you will have to pick subsequent bottoms when fear takes over and greed disappears.
Fortunately, the things that work are simple and straightforward. Do you have the right diversification approach? The traditional 60/40 portfolio still works, and given this year’s price action, it’s easy to be overweight stocks and underweight bonds, which have benefited from high-quality investments triggered by the stock market crash.
The highest flying passenger this year, are you overweight? If so, congratulations, it means you did a great job. But the S&P 500 is up 12% this year, while the S&P 500 equal-weighted index is up just 4%. That means most of the market’s gains this year have been accounted for by the biggest names and the best.
Finally, stick to your plan. Looking back, all of these crashes seem like great buying opportunities. That’s because the U.S. stock market is a place worth being, even if it’s occasionally painful.
Scott Nations is President of Nations Indexes, Inc.
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