Will the stock market crash? Probably so is the short answer.
Data indicates the stock market is in dangerous territory as of Friday, August 8, 2020.
Is the stock market a bubble ready to burst just as it did in the year 2000, and again late in 2007?
Let’s evaluate the topic and end with a data-driven conclusion.
“The most important factor affecting the stock market is Federal Reserve interest rates”
Warren Edward Buffett, a centibillionaire
Will The Stock Market Crash If The Federal Funds Rate Changes?
Each of the last large-scale stock market crashes very closely coincided with Federal Reserve rate cuts. So yes, they are correlated, among other important variables.
Just look at the picture below.
What are interest rates today?
The federal funds rate is presently in the range of 0-0.25%, a historic low. The federal funds rate is the interest rate that depository institutions such as credit unions and banks lend their balances to other institutions on an overnight uncollateralized basis.
The Dot-Com Bubble of 2000 and The Rate Cuts
A few months before the end of the year 2000, the tech bubble burst, sending stocks downward in a panic. Facing an imminent recession, the Federal Reserve waited until Jan 3rd, 2001, to cut the rate by half a percentage point to 6%, this was the first of many rate cuts to try to save the economy, and perhaps, the stock market.
The rate cuts were enacted but did not prevent the onset of the technology bubble crash.
Although rate cuts are precisely calculated, usually to a quarter of one percent, the aggregate human response in the stock market to the rate cuts cannot be controlled. It was the beginning of the end for stocks by summer’s end in 2000—virtually all losses would have been avoided if the danger foretold by the first rate cut on Jan 3, 2001 had been heeded.
Just look at the data below.
The Great Financial Crisis of 2008
On September 18th, 2007, the United States Federal Open Market Committee voted 10 to 0 to enact the first of many rate cuts, from 5.25% to 4.75%—The stock market followed the new sequence of rate cuts as if it were its own shadow.
Just take a look at the picture below.
The Federal Reserve Error of The Century
Leaving rates unchanged from 2008-2015 was undoubtedly the “error of the century” by the Federal Reserve. Let’s explore why that’s the case.
The federal funds rate, as a response to the Great Recession, did not change for 7 years.
It was unprecedented in American history. The stock market is not a part of the real economy, but it influences the real economy.
The stock market influences the real economy because it influences peoples’ consumer spending. When the stocks people own are generally going up in value, they don’t mind spending as they normally do, but when their portfolios are declining in value—for instance 2000 and 2008—they rapidly reduce their spending, thereby affecting the profits of the real economy.
Meanwhile, from December 2008 to December 2015, what did the stock market do?
It nearly tripled. From a low of around 750, to about 2,050.
The stock market recovered, the economy on the other hand, took a few more years to improve its key metrics.
It was an error by the Fed to leave the rate unchanged for such a long period because it created an asset bubble. It’s the fundamental purpose (in addition to price stability (inflation), and full employment) of raising rates, to keep the economy from getting overheated. The stock market is not the economy, but it does influence it.
David Stockman, advisor to former US President Ronald Reagan restates the same case live on CNBC.
“The ZIRP and QE are to blame”
“With the prolonging of the zero interest rate policy and quantitative easing, stock prices became artificially inflated”
“This is really the final spasm of the bull. When this one is over, i think we are all going down for the count” and, “I think it will happen sometime between now and the next election.”
George Soros, a billionaire investor also stated the same position on many occasions. “Low interest rates are conducive to asset bubbles”
The stock market far outpaced the economic recovery.
Recent Fiscal Policy Activities
The U.S. federal government has been pouring money into the economy by the trillions in response to COVID-19 and its threat to the economy. Fiscal policy plays an important role due to its influence on investors’ sentiment about the stock market, its real effects on consumer spending, personal savings, and disposable income.
Recently, it has been the coronavirus stimulus checks, a direct payment to citizens to increase their financial security and safeguard the economy. If federal fiscal policies are reduced or become inadequate to satisfy investors, stock market sentiment will be reduced and could negatively affect stocks.
How Have S&P 500 Per Share Earnings Related to Stock Market Crashes?
When S&P 500 earnings trend downward, investors in the stock market have never fared well.
That’s the story the data indicates.
And how did the stock market fare?
Not good, it was the beginning of a major stock market crash.
What about in 2007, right before the Great Recession?
It was the beginning of another, major stock market crash. Although it took the market roughly a year to recognize the danger that was present in public equity, when the awareness did register, few people wanted to hold onto stocks that were falling in value so rapidly. This was the time period in the final quarter of 2008.
And here we are in 2020, facing another major earnings decline. . .
The Buffett Indicator
The Buffett Indicator was created by investor and businessman, Warren Buffett. According to Warren, “It is probably the best single measure of where market valuations stand at any given moment.”
If a billionaire’s metric cannot be relied on, then whose can?
The Buffett Indicator is found by dividing the Wilshire 5000 Total Market Index, by gross domestic product.
So, let’s plug our data into the formula.
Market cap equals $34.4 trillion, our GDP clocks in at about 19.4 trillion, 34.4/19.4 = 1.77
This ratio is extraordinarily high compared to historical standards.
What was the Buffett Indicator ratio right before the dot-com bubble crash?
The Buffett Indicator registered a last reading of 139.5 on March 30th, 2000. A final warning before the end of the dot-com era, and the stock market.
What does the Buffett Indicator indicate now?
Danger.
The Buffett indicator has never been higher in American financial history than it is currently. It is a not-so-subtle hint that stocks over the next few years are likely to experience a sizable correction, or full-blown bear market. In addition, the US’ GDP is shrinking due to Covid-19 and it’s variants, exacerbating the reality of the computation.
Wall Street’s Fear Gauge Warning
The CBOE Volatility Index, known as Wall Street’s fear gauge, or simply the VIX, is doing something it hasn’t done for almost 20 years, according to global investment bank, Goldman Sachs.
The S&P 500 is up roughly 15% while the VIX has added nearly 105% in value year-over-year.
Usually, when the stock market rises, the volatility index falls, it’s an inverse relation. But currently, they are moving in tandem. The last time this happened was in the year 2000—right before a terrible stock market crash and ensuing bear market.
Political Risks
Mathematically speaking, politics do have some degree of effect upon the tax logic and profits of businesses of every size. According to Forbes, a higher tax rate policy would reduce the S&P 500 earnings estimates by 12%, from $170 per share to about $150 per share, exacerbating the earnings decline that is presently endangering stocks.
The Controversial CAPE Metric/Shiller P/E is Sending Its Warning Again
According to Fortune.com, the CAPE (cyclically-adjusted price-to-earnings ratio) is currently flashing bright red and has only done so 3 times in about 132 years—right before the most brutal stock market crashes of all time.
The first incidence of the CAPE was recorded in August, 1929. It was the month before the beginning of the massive collapse of the stock market, and the onset of the Great Depression. It was a 31.1 ratio.
The CAPE would not reveal itself for another 58 years. The stock market was once again forgetting the lessons of the past. In June 1997, the CAPE reached and surpassed a reading of 31. Amazingly, for many of the months leading up to the end of the dot-com bubble, the CAPE exceeded 40—the only time in history it has done so. And it didn’t end well for stocks, the dot-com bubble burst along with the day trading daydreams of many in late 2000.
It wouldn’t be the last time the CAPE would reveal itself. In June 2007, the CAPE registered again a 31.1 P/E ratio. Right before the Great Financial Crisis of 2008.
On August 5th, 2020, the 31+ cape has once again returned. . .
U.S. Bankruptcies Nearing 10-year high
According to Markets Insider—originally published by S&P Global—424 companies have gone bankrupt through August 9th, 2020. This surpasses the number of bankruptcy filings over any period since 2010. This includes high profile companies such as JCPenney, Neiman Marcus, and J. Crew to name a few. The Covid-19-induced recession is taking a toll on the domestic economy and pushing the unemployment rate into double digits, at a rate of about 10.2% unemplyment, according to bls.gov on June 6, 2020.
Billionaires and Others Opining Concern About The Present Level of The Stock Market
When will the stock market crash?
Ask a billionaire investor.
What does Mark Cuban have to say about the current state of the stock market?
Live on CNBC, Mark Cuban gave a dire warning that the current market environment is similar to 1990s dot-com bubble.
Claiming, “In some respects it’s different because of the Fed and the liquidity,” but that, “On a bigger picture, it’s so similar.”
Will the stock market crash? A billionaire investor affirms the position.
According to intelligence from MIT’s Sloan School of Management, there is presently a 70% chance of recession. The index MIT used clocked in at 76%. Using data as far back as 1916, the researchers found that once the index topped 70%, the probability of a recession increased to 70%.
How Would War or The Threat of War Affect The Stock Market?
Statistically, according to the Swiss Finance Institute, the pre-war phase tends to negatively affect stock prices more than actual wartime. It’s not wartime that affects equity prices as much as the mere threat of military conflict.
In the past, the war theater was more limited than would be in a modern large-scale war and would include more realms. The economy, through the digital infrastructure it is based on would be a prime target in a war among major powers such as the United States, China, or Russia, and would likely sustain much damage across public and private sector digital assets which would affect to some degree the economy.
The Inverted Yield Curve
The inverted yield curve is a noncontroversial indicator of an imminent recession. But what exactly is an inverted yield curve? Before we answer that question, let’s explore the normal yield curve.
The yield cure is a visual representation of yields on bonds of similar quality, across a variety of maturity dates. And it’s not a yield curve of debt from any source, it has to be a debt that is as close to risk-free as possible in order to isolate a clear indicator that isn’t obstructed by other factors in a non-risk-free class. Treasury securities and the federal funds rate are considered risk-free.
It looks like the graph pictured below.
Short-term interest rates are lower than long-term rates because long-term investors are paid a premium price for holding an asset with increased risk over a longer maturity.
Let’s get back the inverted yield question. When the economy starts to have trouble, what does the Fed do? They lower the federal funds rate to lower the costs of borrowing, and improve the economy. If rate cuts are likely to trend downward, then people will naturally prefer to buy the newly-issued, higher interest rate bonds by the U.S. Treasury.
A partial inversion of the curve means that only some of the short-term bonds have higher yields than some long-term bonds. A full-blown inversion of the entire curve means that all short-term bonds of similar quality pay more than the long-term bonds.
The inverted yield curve is downward sloping and is a leading indicator of recessions—a way to predict the turning point in the peak section of the business cycle.
It looks like this.
A Brief History of Inverted Yield Curves And Stock Market Crashes
In 1998, the yield curve briefly inverted, hinting at the impending financial doom-to-come in what would become the dot-com crash.
In 2006 it inverted for much of the year, hinting at the financial danger to come. Stocks made it one more year, then, in late 2007, crashed severely.
In 2019, the curve inverted, the first time since 2007. And again in 2020.
In late February, 2020, the 10-year U.S. Treasury minus the 1-year yield curve briefly inverted, meaning that the U.S. Treasury short-term rate was higher than the long-term Treasury rate. Inversions have occurred prior to recessions in 11 out of 11 recessions in the last 70 years, including the soft landing of 1994, engineered by former Fed chair, Mr. Alan Greenspan.
The curve inverted in early 2019, the Fed reacted with rate cuts, possibly averting or delaying a recession. The chart below, from the Fed, illustrates yield-curve inversions (the red arrow), and the following recessions (the grey line).
Past inversions tend to precede recessions by 12-18 months according to Federal Reserve data. There is a double dipping of the inverted yield curve where the yield curve inverted two, and on occasion, three times before a given recession.
Conclusion
Will the stock market crash? Correlation does not prove causation—but the data must be used conclusively.
From the inverted yield curve to the Buffett Indicator and declining S&P earnings. Moving money out of the stock market and into safety until corporate earnings can recover would be the safest option.
Fiscal stimulus may reverse S&P 500 corporate earnings from a downward curve into an upward one due to the amount of stimulus. Corporate earnings must be watched carefully.
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