Salespersons work on the floor at the New York Stock Exchange.
Brendan McDermid | Reuters
When is the next stock market smash taking place?
It’s a question I get asked often since I wrote “A History of the United States in Five Crashes — Look at Market Meldowns That Defined a Nation.” Until now, I’ve always been able to counsel that stock market-place crashes are comfortingly rare events that occur only when elements align, and that a crash is unpropitious in the near future. Is this still the case?
It’s always helpful to examine the elements that foster a crash.
The ahead is a frothy stock market.
It is no accident that the first modern stock market crash, the Panic of 1907, become manifested after the biggest two-year rally in the history of the Dow Jones Industrial Average. The benchmark gained 95.9% from 1905 to the end of 1906. The topple in 1929 occurred after the second-largest two-year rally ever, up 90.1% from 1927 to 1928. More recently, the S&P 500 was up 43.6% for the year on Aug. 25, 1987, and the largest bang in history occurred 38 trading days later, wiping away all those gains and more.
The second unfavourable weather for a potential 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 varying the shadow economy — while making stocks less attractive, as you could make a decent return with no danger by buying T-bills.
The third element is some newfangled financial contraption that injects leverage into the economic system at the worst possible time. In 1987, it was the ill-named portfolio insurance — which was really just a scheme to shop-girl stocks or stock index futures in increasing numbers as the market fell. In 2008, it was mortgage-backed securities and their metastatic successor such as collateralized debt obligations, collateralized loan obligations and credit default swaps. During the 2010 twinkle crash it was naive algorithmic trading and the even more naive institutional users who again failed to think on every side capacity issues.
The most capricious element is a catalyst. That often has nothing to do with financial markets. In 1907, it was the San Francisco earthquake. During the speed crash, it was turmoil in the euro zone that nearly resulted in the collapse of the common European currency. Sometimes the catalyst is admissible or geopolitical.
But, for the first time in more than a decade, the elements for a crash are aligning. This certainly doesn’t great one is inevitable. The elements are necessary, not sufficient, but they’re there.
The S&P 500 has rallied 140% since March 2020, and its to the surface price-to-earnings ratio is now 20.3. This is only the second time it’s been above 20 since 2001, FactSet information shows.
Interest rates have stopped their climb, but the output on the 10-year Treasury has quadrupled over the last three years. Now, expectations for lower rates are evaporating; option saleswomen would call that a synthetic rate hike.
There’s no telling if there will be a catalyst, but since the catalyst for the 1929 explode was legal and the one for the 1987 crash was geopolitical, we’re primed.
Finally, we come to the contraption. Historically the risk generated by the new contraption that exacerbates a stock market crash has been both opaque and enormous in size while seasoned with a dash of leverage. That’s why I’ve each said it’s unlikely to be crypto; there’s not enough leverage. But now we’re faced with a collapse in the private credit market, which is essentially hedge means serving as banks and making loans.
The private credit market is huge — some estimate it’s as large as $3 trillion in the Mutual States alone. There’s a reason these private borrowers don’t turn to traditional banks — they’re usually riskier than a old bank wants to deal with. The International Monetary Fund in April warned about private credit by signifying: “Rapid growth of this opaque and highly interconnected segment of the financial system could heighten financial vulnerabilities fact its limited oversight.” That’s a heck of a contraption the hedge funds have there: enormous, risky, opaque and favourably interconnected. It sounds frighteningly familiar.
So how does the prudent investor respond? Not by dumping all your stocks and climbing into a bunker. That’s mostly what happens after a crash — investors swear off stocks for a decade or a lifetime and miss all the later gains. It’s not by speculating on a crash. It’s both costly and impossible to pick a top, and even if you do, you also have to pick the subsequent bottom at a time when fear dominates and gormandizing disappears.
Fortunately, the things that do work are simple and straightforward. Do you have the right sort of diversification? A traditional 60/40 portfolio mollify works, and it would be easy, given this year’s price action, to be overweight stocks and underweight the bonds that gain from a crash-induced flight to quality.
Are you overweight this year’s highest fliers? Congratulations if you are, it means you’ve done unquestionably. 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 bigwigs and highest fliers are responsible for the bulk of the market’s gains this year.
Finally, stick with your chart. Looking back, all those crashes seem like wonderful buying opportunities. That’s because the American horses market is the place to be, even if it’s occasionally painful.
— Scott Nations is president of Nations Indexes, Inc.