Traders work on the floor of the New York Stock Exchange.
Brendan McDiarmid | Reuters
It’s always useful to look at the factors that trigger a crash. First, stock prices are overheated.
It’s no coincidence that the first modern stock market crash, the Panic of 1907, occurred after the largest two-year rise in history of the Dow Jones Industrial Average. The index rose 95.9% from 1905 to the end of 1906. The 1929 crash came after the second largest two-year rise in history, when it rose 90.1% from 1927 to 1928. More recently, the S&P 500 was up 43.6% for the year on August 25, 1987, only to have those gains and more wiped out in the largest crash in history 38 trading days later.
The second factor in a potential crash is rising interest rates. It was the Federal Reserve that destabilized the shadow economy by raising short-term interest rates from 1% in May 2004 to 5.25% in September 2006. It also made stocks less attractive because buying government bonds offered ample profits without the risk.
The third element is new financial contraptions that inject leverage into the financial system at the worst possible time. In 1987, it was the infamous portfolio insurance that was really just a scheme to sell more and more stocks or stock index futures as markets fell. In 2008, it was mortgage-backed securities and their metastatic offspring: collateralized debt obligations, collateralized loan obligations, and credit default swaps. The 2010 flash crash was caused by naive algorithmic trading and even more naive institutional investors who again failed to think through the capacity problem.
The most fickle elements are catalysts, which often have nothing to do with financial markets at all. In 1907 it was the San Francisco earthquake. During the Flash Crash, turmoil in the Eurozone nearly led to the collapse of the common European currency. Catalysts can also be legal or geopolitical.
But for the first time in more than a decade, the ingredients for a crash are lining up. This doesn’t mean a crash is inevitable; the ingredients are necessary but not sufficient, but they are there.
The S&P 500 has risen 140% since March 2020 and its forward price-to-earnings ratio is currently 20.3, just the second time it has topped 20 since 2001, according to FactSet data.
Interest rates have stopped rising, but the yield on the 10-year Treasury note has quadrupled over the past three years. Now, hopes of lower interest rates are fading, and options traders will call this a synthetic rise in interest rates.
I don’t know if there will be a catalyst, but the catalyst for the 1929 crash was legal, the catalyst for the 1987 crash was geopolitical, so we will be prepared.
Finally, a word about contraptions. Historically, the risk posed by new contraptions causing stock market crashes has been opaque, huge in scale, and a bit leveraged. That’s why I’ve always said cryptocurrencies are unlikely to be the culprit, because they’re not leveraged enough. But now we’re facing a collapse in the private credit market, which is essentially hedge funds acting as banks and making loans.
The private credit market is huge, some estimate it’s $3 trillion in the US alone. There’s a reason these private borrowers don’t go to traditional banks: they’re usually riskier than traditional banks want to deal with. The International Monetary Fund warned in April about private credit: “The rapid expansion of this opaque, highly interconnected part of the financial system, with limited oversight, may increase financial vulnerabilities.” What hedge funds are playing there is a big one: a huge, risky, opaque, highly interconnected machine. It’s a frighteningly similar story.
So how does a wise investor respond? Not by selling all their stocks and running to the shelter, as is common after a crash. Investors give up on stocks for a decade or even their entire lives, missing out on all subsequent gains. Not by anticipating the crash and responding accordingly. Anticipating the peak is costly and impossible, and even if you could, you would then have to anticipate the subsequent trough when fear takes over and greed fades away.
Fortunately, what actually works is simple and easy to understand: Are you properly diversified? The traditional 60/40 portfolio still works, and given the price volatility this year, it’s easy to be overweight stocks and underweight bonds, which will benefit from a flight to quality as the stock market crash continues.
Are you overweight this year’s hottest performers? If so, congratulations! You’re doing well. But the S&P 500 is up 12% this year, while the S&P 500 Equal Weight Index is up just 4%. That means the bulk of the market’s gains this year have come from big names and hot performers.
Finally, stick to the plan: in retrospect, all of those crashes seem like golden buying opportunities because that’s where the American stock market should be, even if it hurts at times.
Scott Nations is president of Nations Index.
