That’s based on the Shiller P/E ratio, which is derived from average inflation-adjusted earnings from the previous ten years.
Given the lofty heights of the stock market, it would take a 50 percent stock market crash to revert valuations to the mean. In other words, it’s time to be on the lookout for what might trigger this inevitable downturn.
These are the three most likely culprits to cause a stock market crash.
The fact that the stock market has risen on the backs of robust economic growth is also its weakness.
GDP during Trump’s tenure has fluctuated between 2.2 percent and 4.2 percent, setting aside the 1.8 percent of his first quarter in the White House, before his policies were implemented. The average has been 2.9 percent.
The stock market indices, including the Dow Jones, have withstood two consecutive quarters of 2.2-2.3 percent growth. However, if GDP comes in under two percent in two straight quarters, that will likely trigger a major selloff.
It will signal to investors, who have been riding high on a robust economy, that things may be slowing down.
What would make a significant selloff into a full-blown crash would be if this news coincided with some other major event, such as an international crisis, or signs of a massive slowdown in the Chinese economy.
On election night 2016, know-nothings were screaming at Donald Trump, and Dow futures plunged 400 points, leading analysts to warn of a massive stock market crash. They were wrong.
Instead, the S&P 500 is up 43 percent since Donald Trump’s election. That’s because American businesses reversed decade-long economic pessimism with optimism. A businessman was taking over the White House!
Once GDP began exceeding the lackluster average during Obama’s terms, that stoked even more Trump optimism, leading to more economic activity. That has become a virtuous cycle, with stock prices following rising earnings, and also pricing in good times for the near future.
If Trump loses in 2020, especially to any of the business-hating socialists, that will send stocks spiraling.
That’s because the Donald Trump virtuous cycle will reverse into a socialist-driven vicious one, as pessimism tamps down growth.
This warning sign is already flashing red. From this next chart, it is apparent that margin debt is partially behind the stock market’s explosive rise since 2009.
Margin debt is money that institutions and hedge funds borrow to invest in stocks. Margin borrowing enhances returns when the stock market is rising, but also snowballs losses when the market falls.
When the stock market falls, as during the financial crisis, banks demand their money back in what’s known as a “margin call.” Borrowers must sell their holdings to pay the banks, which in turn causes a colossal decline in the market, as falling prices trigger margin calls for other investors.
This was the secondary cause of the 2008 – 2009 stock market crash as a result of the mortgage crisis. As mortgages defaulted, investment banks and institutions had to make good on the defaulted debt they held, which meant liquidating securities. This ushered in a cascade of selling.
Then, as described above, this created great pessimism about the American economy, which begat more selling.
We all know how that ended.
The bottom line for investors: be nimble and have a selling plan firmly in place.
This article was edited by Josiah Wilmoth.
Last modified: May 24, 2019 10:41 UTC