Whether you realize it or not, investors have witnessed history over the past 18 months. They’ve navigated their way through the quickest decline of at least 30% in the history of the benchmark S&P 500 (SNPINDEX: ^GSPC) and have enjoyed the most ferocious bounce-back rally on record. It took less than 17 months for the S&P 500 to more than double from its bear-market bottom.
But if history has anything to say about the stock market in the near term, trouble might be brewing. Five data points all suggest a stock market crash could be on the horizon. Keep in mind that while these data points may be concerning, we can never pinpoint when a crash will happen, how long it’ll last, or how steep the decline will be.
1. Crashes and corrections happen frequently
The first thing to note is simply how often stock market crashes and corrections occur in the S&P 500. According to data provided by market analytics firm Yardeni Research, the benchmark index has undergone 38 declines of at least 10% since the beginning of 1950. This works out to a crash or correction, on average, every 1.87 years. For some context, we’re more than 1.4 years removed from the bear-market bottom of the coronavirus crash and haven’t had even a 5% correction in nine months, as of last weekend.
Admittedly, the stock market doesn’t adhere to averages. If it did, everyone would simply trade based on averages and we’d all be sipping a mai tai on a secluded beach right about now. However, these averages do provide clues about downside frequency that long-term investors should keep in mind.
What’s more, it’s important to understand that the vast majority of crashes and corrections don’t last very long, even if they do occur pretty frequently. The average length of the aforementioned 38 declines since 1950 is 188 calendar days, or about six months. It’s grown even shorter since computers became mainstream on Wall Street in the mid-1980s, with an average correction length of 155 days (five months).
2. Bouncing back from a bear-market bottom is never smooth
The next data point of concern examines how the S&P 500 responds after it finds a bear-market bottom.
As noted, the index took less than 17 months to double in value from its March 2020 low. But if we examine how the S&P 500 responded following the previous eight bear market bottoms, dating back to 1960, you’d see a vastly different story.
Following each of the previous eight bear-market bottoms, there was at least one double-digit-percentage decline within three years. In five out of eight of these bear market bounce-back rallies, there were two double-digit declines. Coming back from whatever pushed the broader market lower by 20% (or more) is a process that takes time. It’s simply never been the straight line higher that we’ve been blessed with since March 23, 2020.
On the flip side, long-term investors can take comfort in the fact that every single crash or correction throughout history has eventually been put in the rearview mirror by a bull market rally. Although the market can be bumpy at times, it does strongly favor the long-term optimist.
3. The S&P 500’s valuation spells trouble
One of the bigger telltale warnings for the stock market has been the S&P 500’s Shiller price-to-earnings ratio. This is a measure that examines inflation-adjusted earnings over the previous 10 years.
For some context, the S&P 500 Shiller P/E closed last week at 38.58, which is nearly a two-decade high. It’s also well over double the average Shiller P/E of 16.84, dating back 151 years.
But it’s not how far above its historic average Shiller P/E that’s of concern. Rather, it’s how the S&P 500 has responded each of the previous times it’s crossed and sustained a P/E of 30. In each of the previous four instances that the S&P 500’s Shiller P/E shot above and sustained 30, the index lost anywhere from 20% to 89% of its value. While the 89% lost during the Great Depression would be virtually impossible today thanks to ongoing intervention from the Federal Reserve and Capitol Hill, the key takeaway is that a 20% decline has been the previous minimum expectation when valuations get this extended to the upside.
However, it is worth pointing out that the democratization of investing brought about by the internet has expanded P/E multiples considerably over the past quarter of a century. With information accessible at the click of a button, rumors no longer weigh down valuations, as they had in the past. Thus, higher Shiller P/E values might become the norm.
4. Inflation could be an ominous sign
A fourth cause for concern is rapidly rising inflation: i.e., the rising price for goods and services.
Earlier this month, the U.S. Bureau of Labor Statistics released inflation data from July. This report showed that the Consumer Price Index for All Urban Consumers rose 5.2% over the past 12 months. That was down ever so slightly from the 5.4% increase in June, which represented a more than 12-year high. When the price rises for the goods and services that people and businesses pay for, it tends to weigh down economic growth (i.e., people/businesses can’t buy as much with the same amount of money).
What’s ominous is how closely related periods of high inflation are to stock market hiccups. For example, the last time the inflation rate topped 5%, the U.S. was in the midst of spiraling into the Great Recession. Looking back a bit further, the inflation rate neared 4% prior to the dot-com bubble bursting. And finally, the inflation rate picked up prior to the recession in 1990-1991.
Understand, however, that correlation does not imply causation. Just because inflation has picked up, it doesn’t guarantee that stocks will head lower. Nevertheless, weaker buying power associated with higher inflation can’t be overlooked as a potential negative for the U.S. economy and equities.
5. Investors are borrowing, and that’s usually bad news
The final data point that should be a cause for concern is margin debt. Margin describes the amount of money investors are borrowing (and paying interest on) to buy or bet against securities.
While not a perfect correlation, rising margin debt has often spelled bad news for the stock market. For example, margin debt jumped approximately sixfold between the 1987 Black Monday crash bottom and the start of the dot-com recession. Since hitting its bear-market low in March 2020, margin debt has practically doubled from a bit over $400 billion to $844.3 billion, according to data from the Financial Industry Regulatory Authority, via Yardeni Research.
Furthermore, the past two times margin debt jumped by at least 60% in a given year came immediately before the dot-com recession and Great Recession. Although margin debt actually declined in July, it was up as much as 70% year to date just a few months prior.
The issue with margin is that lenders (i.e., brokers) can require additional capital be added to an account, or assets be sold, to maintain minimum liquidity requirements. Should a security quickly head in the wrong direction in the short term, forced liquidations via margin calls can cause a cascade crash in the stock market.
As I’ve noted, the use of margin doesn’t guarantee that a crash will occur. But there are enough warning signs here for investors to be aware of the potential for a crash on the horizon.
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