Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
When will the next stock market crash happen?
This is a question I’ve been asked a lot since I wrote A History of the United States in Five Crashes: The Stock Market Crashes That Defined a Nation. Until now, I’ve always been able to say that stock market crashes are comfortingly 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’s always a good idea to examine the elements that contribute to failure.
First, it’s a roaring 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 stock market history. Dow Jones Industrial Average. From 1905 to the end of 1906, the index grew by 95.9%. The 1929 crash came after the second-largest two-year expansion on record, rising 90.1% from 1927 to 1928. 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, wiping out all that growth and more.
The second element of a potential 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 and shook up the underground economy while making stocks less attractive since you could make decent returns without risk by buying stocks. GKO.
The third element is some newfangled financial invention that adds leverage to the financial system at the worst possible time. In 1987, this was called portfolio insurance, which was really just a scheme to sell stocks or stock index futures in ever-increasing quantities as the market fell. In 2008, these were 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 naive algorithmic trading and even more naive institutional users who again failed to think about power issues.
The most capricious element is the catalyst. Often it has nothing to do with financial markets. In 1907 it was the San Francisco earthquake. During the flash crash, it was the turmoil in the eurozone that nearly led to the collapse of the single European currency. Sometimes the catalyst is legal or geopolitical in nature.
But for the first time in more than a decade, the elements of collapse are aligned. This, of course, does not mean that it is inevitable. The elements are necessary but not sufficient, but they are there.
Since March 2020, the S&P 500 is up 140% and its forward price-to-earnings ratio is now 20.3. This is only the second time the rate has topped 20 since 2001, according to FactSet.
Interest rates have stopped rising, but the yield on the 10-year Treasury note has quadrupled over the past three years. Now expectations of lower rates are fading; Options traders would call this a synthetic rate hike.
It remains to be seen whether 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 risk posed by a new invention that fuels a stock market crash has been both opaque and enormous in size, albeit peppered with a small amount of leverage. That’s why I’ve always said it’s unlikely to be a cryptocurrency; Lack of leverage. But now we are faced with the collapse of the private credit market, which is essentially hedge funds acting as banks and making loans.
The private credit market is huge, with some estimates putting it at $3 trillion in the United States alone. There’s a reason these private borrowers don’t go to traditional banks: they’re usually riskier than a traditional bank wants to deal with. International Monetary Fund in April warned about private credit, saying: “The rapid growth of this opaque and highly interconnected segment of the financial system could increase financial vulnerabilities given the limited oversight it has.” It’s one hell of a contraption that hedge funds have: huge, risky, opaque, and highly interconnected. Sounds eerily familiar.
How would a reasonable investor react to this? Without dumping all your supplies and climbing into a bunker. This is usually what happens after a crash: investors get out of stocks for a decade or a lifetime and miss out on all subsequent gains. This is not speculation about a crash. Picking the top is both expensive and impossible, and even if you do, you will also have to pick the subsequent bottom at a time when fear dominates and greed disappears.
Luckily, the things that really work are simple and straightforward. Do you have the right diversification? The traditional 60/40 portfolio still works, and given price action this year, it would be easy to overweight stocks and underweight bonds, which benefited from the flight to quality caused by the crash.
Are you overweight, one of the tallest pilots this year? Congratulations, if yes, that means you did well. But the S&P 500 is up 12% this year, while the S&P 500 Equal Weight Index is up just 4%. This means that the largest companies and the most successful companies have accounted for the majority of the market’s profits this year.
Finally, stick to your plan. In hindsight, all of these crashes seem like great buying opportunities. That’s because the American stock market is the place to be, even if it’s painful at times.
— Scott Nations is President of Nations Indexes, Inc.