Elements for reconciliation of major stock market declines. Why Investors Shouldn’t Panic

When will the next stock market crash happen?

It’s a question I’ve been asked often since I wrote, “A History of the United States in Five Crashes—Stock Market Tumbles That Defined a Nation.” Until now, I have always been able to say that stock market crashes are reassuringly rare events that only happen when the elements align, and that a crash is unlikely in the near future. Is this still the case?

It is always useful to investigate the elements that cause a crash.

The first is a frothy stock market.

It is no coincidence that the first modern stock market crash, the Panic of 1907, occurred after the largest two-year rally in the history of the economy. 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 on record, up 90.1% between 1927 and 1928. More recently, the benchmark S&P500 was up 43.6% for the year on August 25, 1987, and the biggest crash in history occurred 38 trading days later, wiping out all those gains and more.

The second element for a possible crash is rising interest rates. It was the Federal Reserve that pushed short-term interest rates from 1% in May 2004 to 5.25% in September 2006 and disrupted the shadow economy – while making stocks less attractive, because you could earn a decent return by buying stocks without risk. T-bills.

The third element is a new-fangled financial apparatus that injects leverage into the financial system at the worst possible time. In 1987, it was the ill-named portfolio insurance, which was really nothing more than a plan to sell stocks or stock index futures in increasing numbers when the market fell. In 2008, it was mortgage-backed securities and their metastatic descendants, such as collateralized debt obligations, collateralized loan obligations and credit default swaps. During the 2010 flash crash, it was the naive algorithmic trading and the 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 financial markets. In 1907 it was the San Francisco earthquake. During the sudden crash, it was the unrest in the Eurozone that almost resulted in the collapse of the single European currency. Sometimes the catalyst is legal or geopolitical.

But for the first time in more than a decade, the elements for a crash are aligning. This certainly does not mean that this is inevitable. The elements are necessary, not sufficient, but they are there.

The S&P 500 is up 140% since March 2020 and the forward price-to-earnings ratio now stands at 20.3. This is only the second time since 2001 that the value has exceeded 20, FactSet data show.

Interest rates have stopped rising, but the yield on 10-year government bonds has quadrupled in the past three years. Now expectations for lower rates are evaporating; options traders would call this a synthetic interest rate increase.

There’s no telling if there will be a catalyst, but since the catalyst for the 1929 crash was legal and the one for the 1987 crash was geopolitical, we’re ready.

Finally we come to the device. Historically, the risk generated by the new device that causes a stock market crash is both opaque and enormous, yet spiced with a hint of leverage. That’s why I’ve always said it’s unlikely to be about crypto; there is not enough leverage. But now we are facing a collapse of the private credit market, which is essentially made up of hedge funds acting as banks and making loans.

The private credit market is enormous – some estimate it to be as high as $3 trillion in the United States alone. There’s a reason why these retail borrowers don’t turn to traditional banks: they tend to be riskier than what a traditional bank wants to deal with. The International Monetary Fund in April warned about private credit, saying, “Rapid growth of this opaque and highly interconnected segment of the financial system could increase financial vulnerabilities given its limited oversight.” That’s a damn machine the hedge funds have there: huge, risky, opaque and highly interconnected. It sounds eerily familiar.

How does the cautious investor react? Not by dumping all your supplies and climbing into a bunker. That’s usually what happens after a crash: Investors swear off stocks for a decade or a lifetime and miss out on any subsequent gains. It is not by speculating on a crash. It is both expensive and impossible to pick a top, and even if you do, you must also pick the subsequent bottom at a time when fear dominates and greed disappears.

Fortunately, the things that do work are simple and straightforward. Do you have the right kind of diversification? A traditional 60/40 portfolio still works, and given this year’s price action, it would be easy to overweight stocks and underweight bonds benefiting from a crash-induced flight to quality.

Are you overweight among this year’s highest flyers? Congratulations if you are, then it means you did a good job. But the S&P 500 Index is up 12% this year, while the S&P 500 Equal Weight Index is up just 4%. That means the biggest names and highest flyers are responsible for the majority of the market’s gains this year.

Finally, stick to your plan. Looking back, all those crashes seem like great buying opportunities. That’s because the US stock market is the place to be, even if it’s painful at times.

– Scott Nations is President of Nations Indexes, Inc.