You may not like what I’m about to say, but it’s an undisputed truth backed up by data: Stock market crashes and corrections happen all the time.
Since the beginning of 1950, the benchmark S&P 500 (SNPINDEX:^GSPC) has undergone 38 separate crashes or corrections that have led to a decline of at least 10%. This works out to a correction striking the S&P 500, on average, every 1.87 years.
However, the stock market doesn’t adhere to averages, and it often behaves unpredictably, at least in the short term. We’ll never know ahead of time precisely when a stock market crash or correction is going to occur, how long it’ll last, or how steep the drop will be.
But indulge me for a moment, because a confluence of four near-term factors are coming together that may incite a stock market crash very soon.
1. Valuations are stretched to two-decade highs
Perhaps the most front-and-center concern for the market is the valuation of equities, which have catapulted into nothing short of nosebleed territory.
The Shiller S&P 500 price-to-earnings (P/E) ratio — a P/E ratio based on average inflation-adjusted earnings from the previous 10 years — closed at 35.66 on Feb. 11. That marks its highest level since the dot-com bubble nearly two decades ago. It’s also more than double the average Shiller P/E ratio (16.78) over the past 150 years.
On one hand, there are viable reasons for equities to be pricier than they’ve been historically. For example, lending rates are at or near record lows, which has made lending highly advantageous to brand-name and high-growth companies. Additionally, access to the internet since the mid-1990s has helped level the playing field between retail investors and Wall Street. The free flow of information has helped quell rumors and allowed investors to more comfortably value equities at an historic premium.
On the other hand, history has not proved kind to a Shiller P/E ratio that’s north of 30. In the previous four instances where a bull market rally pushed the Shiller P/E sustainably above 30, the S&P 500 lost anywhere from 20% to 89% of its value. While history doesn’t guarantee that’ll happen again, it’s pretty decisive that valuations this high aren’t well-tolerated for long periods of time.
2. Emotions are a kettle that could explode at any time
Over the long run, operating earnings growth is what drives equity valuations higher. But in the short-term, a host of news events and emotions tends to rule the roost. This has been especially apparent in recent weeks, with Reddit retail investors causing dozens of stocks to swing wildly.
Without getting too far into the weeds, retail investors on Reddit’s WallStreetBets chat room initially chose to band together and buy shares and call options on heavily short-sold stocks (i.e., stocks where hedge funds and institutional investors were betting on a move lower). By flooding into stocks like GameStop, retail investors were able to create a short squeeze that sent GameStop and a handful of other selected stocks into the stratosphere.
But the thing about emotion-based investing is that sentiment (1) changes on a dime and (2) often causes investor conviction to overshoot to the upside and downside. The S&P 500 probably didn’t deserve a 34% shellacking in less than five weeks in February-March 2020. Likewise, it probably doesn’t merit a P/E of nearly 36 considering that the U.S. economy hasn’t even fully recovered from the coronavirus disease 2019 (COVID-19) recession.
It wouldn’t take much for emotion-driven momentum traders to send the stock market into a downward spiral.
3. Coronavirus variants threaten to halt progress
No stock market crash discussion would be complete without mentioning the role the COVID-19 pandemic could still play.
In Wall Street’s mind, 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 is going to involve countless detours. The United States has to:
- Secure enough vaccines to cover the adult population.
- Ensure that enough of the population chooses to vaccinate in order to reach herd immunity.
- Distribute the vaccine efficiently to keep doses from going to waste.
- Administer the doses quickly to keep coronavirus mutations and variants from minimizing the effect of the existing vaccines.
Expecting everything to go off without a hitch is foolish (with a small ‘f’). What we know about COVID-19, and how we respond to it from a social and economic perspective, evolves on a month-to-month basis. It’s not out of the question that a COVID-19 variant throws Wall Street and the scientific community for a loop, ultimately instilling panic into emotion-driven investors.
4. A significant decline in buybacks is about the become readily apparent
Lastly, a significant pare down in share repurchase programs over the past six-to-nine months could begin to weigh on equities.
In the two years leading up to the COVID-19 pandemic, S&P 500 buyback activity hit an all-time high. Following the passage of the Tax Cuts and Jobs Act in December 2017, peak corporate tax rates were slashed to an eight-decade low of 21%, which allowed businesses to return more capital to investors.
However, during the height of the coronavirus recession, bank stocks and a host of brand-name companies announced that they’d be reducing or completely shelving their buyback activity to conserve cash. According to market analytics firm Yardeni Research, S&P 500 companies were pacing between $750 billion and $850 billion in annualized buybacks throughout much of 2018 and 2019. As of the third quarter of 2020, annualized S&P 500 buybacks stood at just $407 billion.
Share buybacks have played a notable role in recent years of helping to drive earnings growth — i.e., fewer shares outstanding has led to higher earnings per share. Without this buyback bump, earnings growth could be notably slower than expected in 2021 and ultimately pressure equities.
No matter what happens in the short-term, long-term investors are undefeated if they stay the course. Nevertheless, it might be a smart idea to have some cash at the ready if a stock market crash is around the corner.
