Why the odds of a market crash are increasing

Investors keep looking for a catalyst to trigger a stock plunge. But what if there isn't one?

By MSN Money Partner Dec 30, 2013 3:08PM
Image: Stock market report (© ULTRA.F/Digital Vision/Getty Images)By Henry Blodget, Business Insider

The stock market continues to push higher, on route to posting one of the best years in history.

This advance comes in the fifth year of recovery from the financial crisis, and it has seen the Standard & Poor's 500 Index ($INX) nearly triple off its low of March 2009.


These years of gains have gradually made investors more comfortable again, and now there appears to be a widespread consensus that it's finally "safe" to own stocks.


I own stocks, so I'm certainly enjoying the advance. But unlike some other investors, I'm not feeling more comfortable as they move higher. Rather, I'm feeling less comfortable.


Why?


Because I do not think that time-tested market valuation measures have recently become out-moded and irrelevant. As I've described, these valuation measures suggest that today's stock prices have gotten so extreme that returns over the next decade are likely to be lousy (less than 2% per year, including dividends). So that's what I'm expecting long-term stock returns from these prices to be.


Now, valuation is not helpful as a market-timing tool, so today's prices do not mean that stocks will crash anytime soon (or ever). Instead, stocks could deliver lousy returns just by moving sideways for a decade.


But anyone who has followed the stock market for a while knows that stock prices do not generally correct valuation extremes by moving sideways. Rather, stocks generally correct sharply.


That's why I've said I think the odds of a market crash are increasing.


And I still think that -- more so with every new move up.


Even among investors who are as concerned as I am about long-term valuation measures, however, there is one consistent argument about why there won't be a crash: "There's no catalyst."


Specifically, even cautious investors are concluding (or, at least, hoping) that, because they can't identify what will cause a crash, there won't be one.


And maybe there won't be one.


But I can promise you this: If there is no crash, it won't be because investors can't currently see any "catalyst."


One of the biggest mistakes investors make when it comes to trying to time market turns is in thinking that there will be a clear "catalyst" or "sign" ahead of time that tells them when the market is about to turn.


The truth is that there almost never is.


There are plenty of catalysts and signs in hindsight, of course -- when historians sift through the wreckage and, with the benefit of knowing how things turned out, list all the obvious factors that idiot investors ignored or missed. But, these catalysts and signs are almost never obvious at the time.


(I speak from experience here, by the way. Towards the end of the dotcom bubble in the late 1990s, I was aggressively looking for a sign or "catalyst" that would tell me that it was finally time to lock in the extraordinary gains of the prior five years and head for the sidelines. And so were other investors who had a lot more experience than I did. But this sign, unfortunately, never came — until after the fact. After the fact, as always, it seemed screamingly obvious that the market was about to break down in the spring of 2000 and then, after a confidence-restoring headfake that summer and fall, erase several years of gains in a final, brutal two-year plunge. But most of the warning signs that were visible in 1999 and early 2000 had been visible for years, and that hadn't stopped the advance.)


Today's stock market is nowhere near as overvalued as the one in 2000. And, thankfully, we have not yet reached a price at which long-term stock returns are likely to be negative.

But even those who think that stocks have much farther to run should stop assuring themselves that the market won't crash because there's no visible "catalyst."


Markets don't need a visible "catalyst" to crash.


They just need a minor change in sentiment.


Once stocks start going down, the enthusiasm for buying them at any price will rapidly cool. And the giddy investors who have recently piled up massive levels of margin debt to buy more stocks will rethink the wisdom of this. And the small investors who, finally, after five years of missed gains, have become comfortable enough to put money back into the market will suddenly start to focus on the downside again. And so on.


One investor who has long been concerned about the risk of a crash is John Hussman of the Hussman Funds. This cautious stance, of course, has caused Hussman's funds to underperform badly over the last several years and, as a result, has led many of today's vocal bulls to dismiss him as a moron.


You can view Hussman as a contrary indicator if you like (at your peril -- he's one of the most disciplined analysts around), but at least listen to what he and others have to say about "catalysts":


The immediate objection, of course, is that one does not observe an obvious “catalyst” that would warrant a market decline, much less a crash. As I wrote about our defensive stance during the 2000-2002 decline, "Our positions are always built on observable evidence rather than scenarios. We already have sufficient evidence to be fully defensive. Only later will we read in the headlines exactly why this defensive position was warranted."


As I noted again approaching the 2007 market peak, the need to wait for some observable "catalyst" to justify a defensive stance is reminiscent of other awful consequences of overvalued, overbought, overbullish, rising-yield syndromes, including the 1987 crash: Investors could find no news to explain the crash in that instance, except an unusually large trade gap with Germany, so they continued to fear that particular piece of data. But day-to-day news events rarely "cause" large market movements. . . Once certain extremes are clear in the data, the main cause of a market plunge is usually the inevitability of a market plunge. That's the reason we sometimes have to maintain defensive positions in the face of seemingly good short-term market behavior.


Sornette described this same regularity a decade ago: "The underlying cause of the crash will be found in the preceding months and years, in the progressively increasing build-up of market cooperativity, or effective interactions between investors, often translated into accelerating ascent of the market price. 


"According to this 'critical' point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. Essentially, anything would work once the system is ripe. . . a crash has fundamentally endogenous, or internal origin."


Again, I own stocks, so I certainly won't be unhappy if the market just keeps powering higher.


But I only own stocks because I am comfortable with the idea that the market might drop 40%-60% over the next year or two. If the market does that, I will buy more stocks, just the way I did during the crash of 2008-2009. (I didn't buy enough stocks during this decline, unfortunately. Because, in part, I was stupidly waiting for a clear "sign" or "catalyst" for the upward turn.) 


If you are not comfortable with the idea that stocks could drop 40%-60% over the next couple of years, you should think carefully about how you will feel and behave if they drop, say, 20%-30% (a garden-variety bear-market pullback). And if you conclude that a pullback like that would suddenly dampen your enthusiasm for owning stocks, you might think about re-balancing your portfolio now rather than then. Otherwise, you'll risk making the same mistake that far too many investors made in 2008 and 2009 -- selling near the bottom.


But, regardless, don't waste your time looking for a "catalyst." Chances are, you won't see one until it's too late.


More from Business Insider
81Comments
Dec 30, 2013 3:54PM
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Just looked up one of Hussman's funds (HSTRX).  Since 2002, it is up 10%, the Dow is up 117%.  That's long-term horrible performance, and even it includes the 2008 crash.  I wouldn't listen to a thing that guy says.

I've never understood how a 'professional' can under-perform the market that badly and still be called a professional.  

Hussman's other fund is HSGFX (strategic growth).  Since 2000, it is down .2% while the Dow was up 56%.  

This is a knock on both the credibility of Hussman, and of the author Henry Blodget.  Why would you quote consistent losers??
Dec 30, 2013 4:06PM
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Henry Blodget, the author of this article. Was sent to the Graybar hotel (jail) for stock manipulation in the 2000 crash. Anything more to be said?
Dec 30, 2013 4:06PM
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Yes, isn't it amazing what 75 billion dollars a month can do.
Dec 30, 2013 4:06PM
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Why MSN do you insist on publishig these fear mongering  articles... keep it up,and we will no longer come to this site ... remember, not one --  not one -- of your expert writers saw the tapering scenario. You should be ashamed.
Dec 30, 2013 4:42PM
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Doom and Gloom.  Run for the hills.  Put your money under your mattress.  Buy Gold …. right.  
Dec 30, 2013 4:54PM
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Of course it is always a smart move to be wary of the market's vagaries and the potential for a "drop"; but if one were to become so obsessed with the next downturn; as the author's example of the Hussman fund demonstrates, then any growth of a person's assets would become so stunted that one would have to decide whether which was worse-- a potential lost after gains; or to forfeit any gains at all to feel "safe".  The market is based on the former, not the latter.
Dec 30, 2013 6:44PM
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I just read 6 back-to-back V_L postings.  Excuse me now while I go to the bathroom to cut myself.
Dec 30, 2013 7:06PM
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The markets may go up, they may go down, or they may drift sideways.  When you finally realize that none of this is real, market directions cease to matter.  QE served one great purpose - it allowed us all the time we needed to prepare for the inevitable.  Did you spend your time preparing wisely?  Or were you too mesmerized and hypnotized by the alleged increase in market value of all the pieces of paper you own.  Just remember, only a fool measures his wealth by the alleged value of his assets.  The wise man measures his wealth by the amount of cash flow his assets can consistently generate.

Get busy living, or get busy dying.

Dec 31, 2013 3:17AM
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I am up for a reason...and that reason is I am never afraid to take profits, and I don't cry about the money "I could have made", rather count the money I have made.    


If you think the market is going to drop, take your gains, and move into a nice safe place.   There is no reason you can not get back in anytime you want and there is nothing wrong with sitting on the side lines if you feel uncomfortable with market conditions or pricing.


If you think the market will continue upward, then double down.  Just be prepared to pull the trigger when it goes south.  I've seen too many wanting just a little more, or to hit that magic number, and ride it back down.


I myself am heading to the bench and sitting this one out.   I hope it continues, because it is all intertwined to a certain degree, and I am never left with out a modest position in play.   Like I said, no one ever said you can't get back in if conditions suit you.

Dec 30, 2013 5:53PM
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This so called "catalyst" the article keeps mentioning will be the day when mutual funds have satiated the market with 401k money. This year, for the first time in 5 years, money started moving into mutual funds instead of out of them into gold, bonds etc like they have in years past. As the momentum builds as more fund managers pile money into stock funds and they receive more from small investors through their 401k's (and this will continue for awhile at least) then the market will continue to go up based on the sheer volume of money being poured into these stock mutual funds. There may be a few mini faker crashes along the way but when those stock mutual funds get to the point where they are overflowing with money then there will be a real crash.  Historical P/E ratios for most stocks aside from huge companies aren't as bad as they were around 2007.  I remember around 2005 when everyone kept believing in the market going higher thinking historical PE's had started to get out of hand.  In 2008, I told my roommate at the time that there would be a crash because historical P/E's had gotten ridiculous and when the market was around 13,000 I told him I expected it to hit 6200 within a year since at that point it P/E's would look normal. It hit around 6600 so I was off by about 400 points.  Historical P/E's don't always work but they are still a good general indicator of where things are in the market.   
Dec 30, 2013 5:04PM
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Our monetary system isn't what it used to be.  Sooner or later, the dollar is going to have an accelerated death and imminent take-over by something more stable and THAT is when the worst kind of fear we've ever known will overcome the market.
Dec 31, 2013 1:35PM
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Crazy....I am a Moderate, with Conservative Fiscal leanings..

Consider myself a Constitutionalist..

But am Liberal in a few beliefs, that don't affect us directly...That are not our business.

That is where the Freedoms for man or womankind enter the picture.

Dec 30, 2013 4:23PM
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Nice Morels...kidtrick.


And that looks like Devil's Tower....Blubal42.


Ah, what the hell;  The Glass is "half full"...We will fill it in 2014...

Happy New Year...

Dec 30, 2013 6:33PM
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Sometimes when I'm feeling nervous about the market, I just jump on to any MSN Money article thread and read to get uplifted.  All this doom, gloom and pessimism.  It reassures me that this bull still has room to run.  I especially get uplifted if I spot a V_L posting.
Dec 31, 2013 9:31AM
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I agree and I am just waiting for 2014 to sell more of my winners. The money will stay in cash until after the next big pullback. Since the FED is doing a very slow pullback it may not happen for awhile, but why risk it. Everyone with a brain knows it's only the FED propping up this market.

Dec 31, 2013 10:35AM
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Is Mr. Blodget still recommending Worldcom?? This guy makes the case for torture and death squads
Dec 30, 2013 5:55PM
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If a person is so certain stocks will drop 40-60% soon, that person would wait and buy all their stocks then. So I call BS on this article. Eventually what worked in the past won't work in the future. So saying what you did back in 2000 and 2009 is hardly a case for doing the same in the Future. We are literally in uncharted waters. You cannot nor should anyone use the past to predict the future. All we can do is look at the facts on the ground and assume the rest. What do we really know at this point.

1)Corporations are the Biggest Drivers of the Stock Market due to low rates and thus massive Stock Buybacks.
2)We are at Record Margin for Buying Stocks
3)$4Trillion in Corporate Paper in coming due in the next 4 years
4)Euro-zone Unemployment is still above 12%
5)The Fed's Bloated balance sheet is at or near $4Trillion
6)Japan is about to raise it's sales tax from 5% to 8% to 10%
7)China is a massive Credit Bubble
8)The Wage Gap keeps Growing
9)The Past is never a promise of the Future.


Dec 30, 2013 5:46PM
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I can't help but think the people writing this type of story are trying to short sell the market.
Dec 31, 2013 9:31AM
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Pay no attention to the dart throwing chimps; pick an asset allocation you are comfortable with and rebalance annually. Then don't worry about it. Not sexy, but it works.


Besides, one shouldn't worry about what the market is going to do, one should look at the underlying business fundamentals. Call me optimistic, but I see more opportunity today than at any time in my life (which goes back to Eisenhower admin.) That is, IF we can get government out of the way.





Dec 30, 2013 6:39PM
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The institutions don't make any money in a calm market. They prefer a scared marketing, one that is moving up or down rapidly so they can take advantage of investors and churn.
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