History suggests a stock market crash is likely: 5 worrisome pieces of data
Whether you are aware of it or not, investors have seen history in the last 18 months. You've seen the fastest decline of at least 30% in the history of the S&P 500 (WKN: A0AET0) and then enjoyed the strongest recovery ever. It took less than 17 months for the S&P 500 to more than double from its bear market lows.
But if history is anything to go by about the stock market in the near future, trouble could be brewing. Five pieces of data suggest a stock market crash could be on the horizon. Keep in mind that while this data may be concerning, we can never tell exactly when a crash will occur, how long it will last, or how severe the decline will be.
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1. Crashes and corrections occur frequently
The first thing to note is how common crashes and corrections are in the S&P 500. According to market analysis firm Yardeni Research, the benchmark has seen 38 declines of at least 10% since the early 1950s. This means that, on average, a crash or correction occurs every 1.87 years. By comparison, the low point of the bear market after the coronavirus crash was more than 1.4 years ago, and since last weekend there has not even been a 5% correction in nine months.
Admittedly, the stock market does not adhere to averages. If it were, everyone would just act on averages and we'd all be drinking a Mai Tai on a deserted beach right now. However, these averages provide clues to the frequency of price declines that long-term investors should keep in mind.
Furthermore, it is important to understand that the vast majority of crashes and corrections do not last very long, even if they occur quite frequently. The average duration of the above 38 declines since 1950 is 188 calendar days, or about six months. It's gotten even shorter since computers took over Wall Street in the mid-1980s, with an average correction period of 155 days (five months).
2. The return from a bear market low is never smooth
The next worrisome data point concerns the S&P 500's reaction after hitting a bear market bottom.
As noted, it took the index less than 17 months to double in value from its March 2020 low. However, if we examine how the S&P 500 has reacted after eight previous bear market lows dating back to 1960, we see a completely different picture.
After each of the eight previous lows, there has been at least one double-digit percentage decline in three years. Five out of eight of these bear market recoveries have seen two double-digit declines. Recovering from what has pushed the broader market down 20% (or more) is a process that takes time. Things have simply never gone as straight up as we've seen since 23. March 2020 were allowed to experience.
On the other hand, long-term investors can take comfort in the fact that every single crash or correction throughout history has eventually disappeared through a bull market in the rearview mirror. Although the market can be bumpy at times, it is very favorable for long-term optimists.
3. The valuation of the S&P 500 poses problems
One of the biggest warning signals for the stock market was the Shiller price-earnings ratio of the S&P 500. This is a measure that looks at inflation-adjusted profits over the last 10 years.
By comparison, the S&P 500's Shiller price-to-earnings ratio closed last week at 38.58, its highest level in nearly two decades. It's also well over double the average Shiller P/E of 16.84, going back 151 years.
What is worrying, however, is not how far the Shiller P/E ratio is above its historical average. Rather, it's how the S&P 500 has reacted each time it has exceeded and held a P/E ratio of 30. In each of the last four instances where the S&P 500's Shiller P/E ratio rose above 30 and held there, the index lost between 20% and 89% of its value. While the 89% lost during the Great Depression would be virtually impossible today thanks to constant intervention by the Federal Reserve and Capitol Hill, the most important lesson is that a 20% decline was the minimum expectation to date when valuations move up that far.
It should be noted, however, that the democratization of investing through the Internet has significantly increased P/E ratios over the past quarter century. With information available at the click of a mouse, rumors no longer weigh down ratings as they did in the past. As a result, higher Shiller P/E ratios could become the norm.
4. Inflation could be an ominous sign
A fourth cause for concern is rapidly rising inflation, d. h. the increase in prices for goods and services.
Earlier this month, the U.S. Bureau of Labor Statistics released inflation data for July. This report showed that the consumer price index for all urban consumers has increased by 5.2% in the last 12 months. This was a slight decrease from the 5.4% increase in June, which was a 12-year high. When prices rise for the goods and services that people and businesses pay for, economic growth tends to slow (d. h. people/companies can't buy as much with the same amount of money).
What is worrying is how closely times of high inflation are linked to problems on the stock exchange. For example, the last time inflation exceeded 5%, the U.S. was in the midst of a financial crisis. If you look back a bit further, the inflation rate before the dotcom bubble burst was almost 4%. And finally, the inflation rate picked up before the recession of 1990-1991.
It should be noted, however, that correlation is not synonymous with causality. Just because inflation has picked up is no guarantee that share prices will fall. Still, the weaker purchasing power that comes with higher inflation cannot be overlooked as a potential detriment to the U.S. economy and stocks.
5. Beginners take out loans, and this is usually bad news
The final data point that should be of concern is margin debt. Margin describes the amount of money investors borrow (and pay interest on) to buy or bet against securities.
Although the correlation is not perfect, rising margin debt has often been a bad sign for the stock market in the past. For example, margin debt increased about six-fold between the low point of Black Monday in 1987 and the beginning of the dot-com recession. Since the bottom of the bear market in March 2020, margin debt has virtually doubled from just over 400 billion. US dollar to 844.3 billion. U.S. dollars, according to data from the Financial Industry Regulatory Authority provided by Yardeni Research.
The last two times margin debt increased by at least 60% in one year, it happened just before the dot-com recession and the financial crisis. Although margin debt actually declined in July, it rose as much as 70% year-over-year just a few months earlier.
The problem with margin is that lenders (d. h. Brokers) may require additional capital to be deposited into an account or assets to be sold to meet minimum liquidity requirements. If a security quickly moves in the wrong direction in the short term, forced liquidations via margin calls can cause a cascading crash on the stock market.
As I mentioned earlier, this is no guarantee that a crash will occur. However, there are enough warning signs to alert investors to the possibility of an impending crash.
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This article reflects the opinion of the author, which may not be consistent with the "official" recommendation position of a The Motley Fool premium advisory service. Questioning an investment thesis – even one of our own – helps us all think critically about investments and make decisions that help us become smarter, happier and wealthier.