- All indicators show a stock market crash is imminent, but what will the trigger be?
- I’ll discuss what can happen and how bad it could get.
- As for the timing of it, the best thing is to be prepared for anything.
To see whether the stock market will crash in 2018 or not, we have to first see what makes a stock market crash and the best way to do that is to look at the 2001 and 2008 market crashes because the financial environment prior to those crashes resembles the current market environment.
We’ve seen two declines of about 50% in the last 17 years which is an extremely important fact to keep in mind especially because the environment prior to both of those crashes was similar to the environment we have now where stocks seem, and seemed to be, riskless.
For the first, the market peaked on March 10, 2000 when it became obvious that the extremely high valuations were impossible to justify and that the internet wouldn’t be as profitable as hoped after all.
In 2000, the S&P 500 PE ratio reached 34 while today it’s above 25. That might seem like a big difference from a relative perspective, but from an absolute perspective, both levels are extremely risky.
To add fuel to the fire, the economy entered into a recession in March 2001 which deepened the panic and led to the stock market falling until September 2002 then staying low until March 2003 for a total decline of about 50%.
In 2007, the market peaked in October only to precipitously fall up until the 9th of March 2009 for another 50% drop. The valuations were much healthier back then with the PE ratio of the S&P 500 being around 20 in October 2007, while it was 28.31 in March 2000.
To keep things short, the 2008 market crash was caused by a change in the risk perception where suddenly it became clear that many lenders—among which many were institutions and countries—were over leveraged, making it an unsustainable situation. The trigger was the bursting of the U.S. housing market which made the house of cards fall.
It’s easy to conclude that both stock market crashes were caused by excessive leverage. In the dotcom bubble, the leverage was mostly in the form of equity while in great financial crisis, it was in the form of actual debt.
The first thing we have to determine is whether the current stock market and economic system is a house of cards and whether it could be prone to an economic collapse. We could imagine that the system would be much safer as we learned an important lesson in 2009 and, consequently, have patiently worked on deleveraging in order to create a more stable financial system, right?
The opposite has happened. Central banks decided to solve the 2009 leverage issues with even more leverage. I don’t think we have to debate much over that. Interest rates are at extremely low levels, debt levels are growing, and everyone is high on huge market liquidity. Government debt has just been piling up in the last 8 years, and nobody seems to care.
U.S. public debt went from 60% of GDP to the current 103% in a matter of just a few years. The debt to GDP ratio was just 30% in 1982, and the situation is even worse in Europe.
At some point, especially if interest rates rise, that debt will become a huge burden and will lead to financial turmoil.
Similarly, margin debt is at historical levels which is extremely important because in the case of a margin correction, all those margins will get a margin call and will probably be forced to sell.
So all the factors indicate a stock market crash is imminent and could happen any time. Those who didn’t witness the crashes in 2001 and 2008—and also many of those who did—probably won’t believe me but if you’ve read my article on recency bias, you know that investors tend to make investing decisions on what happened recently and not 8 years ago. Therefore, it’s important to see what the shocks are that could make the house of cards fall.
It’s important to understand that there is no localized economy anymore in the world as everything is intertwined, thus a shock in Europe could lead to a global recession and a crash, for example. Also, risks can build up for a long time before actually triggering a crisis. At point it happens, everyone will seemed surprised but the in retrospect, it’ll all be so obvious.
The Main Risk Is Government Debt & Central Banks
Central Banks have created this situation as their share in GDP was minimal in 2007, and now it’s close to 40%. This includes the FED, ECB, BOJ, and BOE.
Therefore, the first potential shock could come from increased tightening if we see inflation or something similar. It might look impossible at this point in time as it looks like central banks will do everything to save the situation, but don’t forget that central banks can also lose control. If that happens, we will probably see stagflation. Thus, higher interest rates, inflation, and an economic downturn. Such a situation would be very difficult for all those governments with high debt burdens.
You might think it’s impossible for stagflation to happen but to see such a situation with high inflation in combination with a recession, you don’t have to look that far back in history.
In 1974 and 1975, U.S. GDP contracted while inflation was above 7%. The situation was even worse in 1980 and 1982 with U.S. GDP contracting and inflation at 12.4% in 1980 and 7.4% in 1982 alongside a 1.9% GDP drop.
Given the huge amounts of money and debt dependency most key global players have—from governments to institutions and corporations—and the potentially huge demand coming from emerging markets, I wouldn’t be surprised to see a 1970s scenario again. With the only difference being that it could happen much faster due to the high debt levels and monetary easing policies.
The effect on the stock market would be devastating.
The S&P 500 PE ratio in the 1970s was mostly below 10 and even went below 7 in May 1980. A PE ratio of 7 on current earnings would imply an S&P 500 value of 743. Don’t believe that’s possible? Well, you don’t have to go back to the 1980s. On March 9, 2009, the S&P 500 closed at 676 points. This implies a 74% decline from current levels, something very plausible and something to be prepared for.
As soon as debt gets out of control, mark my words. I just don’t know when it will happen, but there will be huge bells ringing that no one will want to see. I’ll inform you when that happens.
Political Turmoil In Europe
On May 20, 2018, there will be elections in Italy. The ECB has brought the Italian interest rate to negative to keep the status quo, just as it did with France in their last election.
How long will the ECB manage to keep the status quo? No one knows, but the Euro will get weaker and that will have consequences.
Price Increases In Commodities
Higher commodity prices due to emerging market demand could really put pressure on Europe and other developed countries that play on weakening their currencies. Higher prices would lead to inflation which would make it difficult to keep interest rates low.
The Black Swan
This is the most likely trigger for the next recession. A black swan is something that no one sees coming beforehand but is so easy to explain after the fact.
It’s impossible to know what will happen, so the best thing to do is to be prepared for everything. Tomorrow we will discuss how to be prepared for the imminent 2018 stock market crash and economic collapse.