Is there a stock market crash coming in 2019?
Making economic predictions is a journey fraught with danger. But we can examine the evidence, and weigh the historical support for the perspective that the US economy is now primed for a recession.
As investors, we are primarily interested in the effects of the said recession on the markets and our investments. A recession will cool the overheated stock market. We all wish for a soft landing, but in all likelihood, we will get a stock market crash, followed by a slow normalisation of the valuations.
What is a Stock Market Crash?
A stock market crash is a rapid decline in stock prices across the board. If you wake up to a stock market crash, with a fully invested portfolio, you will feel a hard punch in your guts as you watch a significant paper wealth destroyed.
The stock market crash can be triggered by economic events and trends. Or it could be just a natural process when a speculative bubble in asset prices finally reach a popping point. Whatever be the reason for market crash, it is undeniable that the effects on the economy, investors, and regular citizens can be devastating and long lasting. You can read more about the stock market crash that was followed with the great depression here.
A stock market crash occurs over a matter of days, and can eventually lead to a market correction (declines of 20% or more from the peak). A crash and/or a correction can be a forerunner to a wider economic recession (2 consecutive quarters of negative GDP growth).
7 Reasons for Stock Market Crash in 2019s
Risks to the stock prices abound. We look at several different types of risks today.
1. Yield Curve inversion – is not just a predictor of an upcoming recession, but it can cause recession
This was all the news in March 2019. The short term interest rate (3 month T bill) become higher than the long term interest rate (10-year treasury notes). This is important as inversions have preceded each of the past 7 recessions and is considered a very reliable predictor of a recession.
In fact, the St. Louis Fed argues that an inverted yield curve makes it more attractive for banks to favor short term loans over long term credit, thereby skewing the capital funding environment that leads to companies pulling back on new investments and is therefore can directly cause a recession.
2. Full employment – this has close to full correlation with recessions
There is no other way but up.
When the unemployment rate drops very low, businesses find it difficult and prohibitively expensive to hire new employees. Costs increase and profits decline. This causes businesses on the margins to fold. The unemployment rate eventually starts creeping up and the economy goes into a recessionary decline.
We are currently enjoying a historically low 3.8% unemployment rate and this worries me a lot.
There is a fascinating study comparing the predictive power of Yield Curve Inversion vs the Unemployment Rate for recessions. For our purposes, we need to remember that overall both the indicators are reliable signals of upcoming recession.
3. Lop sided gains dominated by select stocks – these stocks are momentum driven and can fall as fast if the investors sour on them
The markets have done very well since 2009. Or have they?
If you bought major indices such as S&P 500, or Nasdaq, you have truly done well. If you bought a few selected tech stocks, you may have done spetacularly well. However, most stock investors have been battered and bruised as the stock market in general has performed abysmally in the last decade (save for a few selected stocks).
We have not seen a healthy broad based market rally in over a decade.
The problem with momentum driven markets is that momentum eventually fades.
4. Shiller PE Ratio – Currently at levels not seen since the great depression
The Cyclically Adjusted PE Ratio (CAPE), also called Shiller PE, is currently at 30.62. This is higher than Black Monday (1987) and close to Black Tuesday (1929 – start of the great depression).
This presents a conundrum. As we said earlier, most of the market has not participated in the growth since 2009, but the narrow segment that did, has stretched the valuations quite high. So even if the valuations in large swathes of the market may not be that high, the market risk due to the extremely overvalued stocks is very significant at this time.
5. Quantitative trading or program trading bots – increases volatility and amplifies any declines or rise
The swarms of program trading bots are meant to exploit every possible opportunity and make the markets more efficient. In reality, they increase volatility and amplify the extremes.
I suspect the lop-sided market gains have a lot to do with the herding behavior exhibited by these bots.
6. Investors are missing from this rally – company buybacks are driving the stock prices while private investors, institutions and funds are pulling back
I think most investors are quite rational. Companies on the other hand may not be when it comes to stock buybacks. It is also possible that one time tax boosts created an environment where there was excess cash on the companies’ balance sheets that needed to be used to “create more shareholder value” by the way of stock buybacks.
This will naturally stop.
7. Trade war prospects – irrational trade policies that are designed to put US at an economic disadvantage
Trade wars do not help. They create unnecessary drag on the economy, adds to the cost of doing business, and creates uncertainty for the investors and business managers.
We are sitting at a confluence of multiple factors that can lead to a recession and a market correction, perhaps a crash.
Effects of the Wall Street Crash
Effects of the crash can be devastating but temporary. A recession can be prolonged, but the economy eventually recovers. Most of us have lived through the 2008 recession that caused significant job losses, and the erosion in wealth. It is not something that we want to happen as it is also a dent on consumer confidence.
How to Protect Your Portfolio During a Market Crash
As investors, we also realize that the market declines offer great opportunity to buy valuable stocks and other assets at attractive prices. However, to take advantage of this rare opportunity requres something very fundamental – we have the means and the guts to do it.
Earlier I recommended that investors prioritize cash to lock in the current market valuations and be ready to invest as the prices decline. Also be on the lookout for great businesses that you would like to acquire should the prices decline enough to make it very attractive – and then follow up with these purchases. If you are not sure how to do this, or are not confident enough to do it on your own, we can help.