What I'm about to say is going to unnerve some of you, but it's the absolute truth: A stock market crash might be imminent.
Since hitting a bear-market bottom on March 23, 2020, the three major U.S. indexes have been virtually unstoppable. Through April 6, 2021, the tech-dependent Nasdaq Composite (NASDAQINDEX: ^IXIC) has doubled, while the benchmark S&P 500 (SNPINDEX: ^GSPC) and iconic Dow Jones Industrial Average (DJINDICES: ^DJI) were up a respective 82% and 80%. There's not an optimist on Wall Street who would be dissatisfied with gains like these in just over one year's time.
The question is whether or not these gains will prove fleeting.
Signs point to a potential crash
Right now, there is no shortage of catalysts that could knock this market off its perch.
In recent months, Wall Street has been worried about rapidly rising Treasury yields. Keep in mind that when I say “rapidly rising,” some context is needed. Although 10-year Treasury yields have doubled over the last five months, a 1.7% yield is still historically very low.
Nevertheless, investors are concerned about the potential for higher lending rates, which could slow the borrowing capacity and growth prospects for the dozens of fast-paced and innovative companies that have led the stock market higher. It could also signal an uptick in inflation and force the Federal Reserve to consider raising interest rates earlier than expected.
Another chief concern is equity valuations. Dating back 150 years, there have only been five instances where the S&P 500's Shiller price-to-earnings (P/E) ratio has surpassed and sustained 30. The Shiller P/E ratio measures average inflation-adjusted earnings from the previous 10 years and is also known as the cyclically adjusted P/E ratio, or CAPE. On April 6, the Shiller P/E ratio for the S&P 500 was nearly 36.7, which is well over double its historic average of 16.8.
Furthermore, in the previous four instances where the S&P 500's Shiller P/E hit 30, the index lost anywhere from 20% to as much as 89% of its value. Although we're unlikely to see Great Depression-like losses of 89% ever again, at least a 20% decline has been the recipe when valuations get extended.
The coronavirus pandemic also remains a concern. Though the light at the end of the tunnel is now visible, variants of the disease threaten to minimize vaccine efficacy or push herd immunity (i.e., a return to normal) further down the line.
Three things to do right now
So, what's an investor to do?
1. Realize that downside catalysts always exist and don't overreact
The first thing is to relax and realize that there's always a catalyst waiting in the wings that could send the market screaming lower. Whether we're mired in a recession or the economy is firing on all cylinders, I can't recall a time in my more than two decades of investing where the warning siren hasn't been sounding about one thing or another.
Investors should understand that stock market crashes and corrections are a normal part of the investing cycle and the so-called price of admission to the greatest wealth creator on the planet. With the S&P 500 experiencing a double-digit decline every 1.87 years, on average, since the beginning of 1950, it's important not to overreact to sharp or sudden moves lower in the market. It also helps knowing that these moves lower usually don't last very long.
2. Reassess what you own
Secondly, and to build on the previous point, it's always a good time to reassess your portfolio and reaffirm your investment thesis. In other words, take a closer look at the companies you own stakes in and revisit the reason(s) why you purchased them in the first place. There's a very good chance that a stock market crash is going to have little or no long-term effect on the underlying performance of the companies you've invested in and is therefore going to have no impact on your investment thesis.
Keep in mind that you don't need to wait for a stock market crash, or even the threat of a crash, to do this a couple of times a year. Ensuring that your investment thesis still holds water will minimize the emotional aspects of stock market corrections and crashes and make it a lot easier to hold on to great stocks.
3. Have cash at the ready for when opportunity comes knocking
The third thing to do is build up a healthy cash position so you can take advantage of the market's inevitable downturns. You see, despite the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite undergoing dozens of double-digit corrections and crashes throughout their history, each and every one of these moves lower has eventually been erased by a bull market rally.
In fact, data from Crestmont Research shows that at no point between 1919 and 2020 have rolling 20-year total returns (including dividends) ever been negative. If you bought an S&P 500 tracking index at any point over the past 102 years and held on to your investment for a minimum of 20 years, you made money.
When the next correction or crash does rear its head, be thankful, because you're being given an opportunity to buy great companies at a discount.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.