This Is What Could Keep The Stock Market From Crashing

February 6, 2018

This Is What Could Keep The Stock Market From Crashing

  • There are scenarios that could see stocks double from current levels, no matter how crazy those scenarios might look now.
  • I’ll explain what’s going on, why, and what can you do about it.
  • No one can know exactly what will happen, so the key is to be prepared for anything.



Introduction

After yesterday, many are expecting a stock market crash. And by looking at what happened in 2000 and 2009, it seems pretty logical that the market will crash as things are looking ridiculous.

Figure 1: The S&P 500 has had two 50% crashes in the last 20 years. Source: Multpl.

However, the market is always there to surprise us and therefore it’s good to discuss alternative scenarios. Today, we’re going to discuss a few scenarios where things change without a stock market crash. On the contrary, the S&P 500 could double but you wouldn’t be happy about it.

The possible scenarios are: central banks buy stocks, there’s a currency meltdown and higher inflation, or there’s extreme growth of market leading companies.

Divine Intervention

Stocks usually crash in a recession as doing business gets tough, people spend less, the companies that overspent or are over-leveraged themselves go bankrupt, and all of that has a negative impact on revenues, margins and, consequently, earnings. Lower earnings in combination with declining stock prices lead to panic as investors get scared that the situation might get much worse and sell their stocks.

But there are a lot of indicators showing how the situation has changed in the last 8 years and we might not see a crash because it won’t be allowed. If you read the minutes of the FED meetings, you’ll see that 50% of the discussion is about the economy and 50% about financial markets. This leads us to believe that the FED will do everything to keep financial markets strong as the apparent wealth from high stock prices increases customer confidence and keeps the economy stable.

So if the FED, and ECB get scared that financial market panic might negatively impact the economy as lower stock prices lead to lots of issues with retirement payments, equity financing, wealth feeling, etc., they might start buying stocks directly which would turn around the panic mode and push the stock market to new highs.

Think this is science fiction? Well, the Bank of Japan has been doing exactly that for a while now. The BOJ owns 75% of Japan’s ETFs.

Figure 2: A central bank is buying stocks, crazy but true. Source: Zero Hedge.

So with a buyer like the central bank, how can stocks perform? Well, the Nikkei has tripled since 2009 and has really started surging since the BOJ increased its purchasing activity.

Figure 3: The Nikkei index in the last 20 years. Source: Google.

So if the Japanese do everything to keep stocks high, why wouldn’t the ECB—which is doing something similar already by buying corporate bonds—and the FED do the same? Perhaps there might be a correction, but if the FED steps in we might see no crash and much higher stock prices.

If that happens, the question is what would the FED buy? Given their mindset, most probably ETFs, so it’s important to hold assets that are held by ETFs, thus the companies with the largest market capitalizations.

Figure 4: S&P 500 top constituents would mostly benefit form central bank activity. Source: S&P Dow Jones Indices.



A Global Currency Meltdown

Global central banks have really injected incredible quantities of money into the system in the last 9 years.

Figure 5: FED, ECB, and BOJ balance sheets have all quadrupled in the last 9 years. Source: FRED.

Just compare the situation before 2009 and after. Before 2009, most balance sheets were stable and flat, and then there was an explosion which is still going on in Europe and Japan. What has happened in the U.S. is that the money supply has double in the last 9 years, and the currency is worth much less than what the public perceives at the moment. Given that, we could see serious inflation, especially if central banks can’t increase interest rates due to a recession.

Am I talking science fiction again? Look at Argentina, which has seen its economy struggle in the last 5 years with two recessions.

Figure 6: GDP growth in Argentina over the last 5 years. Source: Trading Economics.

The recessions have been combined with extreme inflation levels.

Figure 7: Inflation in Argentina in the last 5 years. Source: Trading Economics.

And, despite everything, the Argentinian stock market has increased 5 times in the last 5 years.

Figure 8: Argentinian stock market index – MERVAL. Source: Trading Economics.

This is something that could easily happen in the developed world too if there is stagflation – rising inflation in combination with economic stagnation. In order to be protected, one has to own some gold hedges, producing assets like real estate, and fixed interest debt is also not a bad idea.

Big Companies Get Bigger & Bigger

The third scenario is one where the biggest companies in the world—which have the most cash and power—continue to grow at staggering rates, disrupt even more their respective business sectors, continue to grow in a recession, and come out even stronger. Given that the top 10 companies of the S&P 500 make up 20% of the whole index, leaving the remaining 80% to 490 companies, what happens to the biggest companies out there matters the most.

Figure 9: S&P 500 index and weights. Source: S&P Dow Jones Indices.



Given their cash power, information, potential for disruption, and huge market capitalizations, these companies could soon make up 50% of the S&P 500 and if people flight to them for safety, the S&P 500 might not crash even if 490 stocks crash.

Be Prepared For Everything

Now, you might wonder what the probability is of any of the above scenarios happening. The point is that it doesn’t really matter.

The problem is that you have to be prepared for everything. Let’s say you think stocks are expensive, sell all your holdings, wait in cash, and then suddenly the FED starts buying stocks in combination with ramping inflation to 15%. You would quickly lose a lot of value due to currency depreciation which is something you can’t afford, ever. Therefore, the point is to be prepared for anything, have huge upside if any of the above scenarios happen, and also be protected from the downside.

The key in investing today is to be prepared for everything. I haven’t been a huge fan of an all-weather portfolio in the past as long-term trends aren’t that difficult to forecast, but at this point in time, all-weather is really something to look at in order to be protected and make decent returns no matter what happens. You can read more about how to construct an all-weather portfolio here.