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?
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.
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
Get busy living, or get busy dying.
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.
lol, this isn't bridge building here - there are many more variables and major market psychology at play. before you plunk down the family farm on the social networking etf, try the following quiz:
1. please explain what a simple-moving-average is and what generally happens when an index becomes disconnected from the 200, 125 and 50 day sma's
2. please explain to us what the "vix" is and why it rose 8.83% today
3. please explain the "SKEW" index and why it is at the highest level of alert in years
4. please explain why the market dropped 23% in one day in october 1987 and then why it will not happen again, i.e. what specific safeguards are now in place to prevent a recurrence
5. please explain the cnn "fear and greed" index and why multiple factors now flash "extreme greed" but yet this is not a problem and not to be heeded
6. please explain how the upcoming debt-ceiling debate will be different this time
7. please explain why the pending home sales just dropped in reaction to tighter credit, less employed buyers and higher interest rates and what will fix this before it causes a downturn
8. please explain why twitter dropped 18% in two days and why this will not happen with amazon, apple, netflix, fedex, wynn, facebook, tesla, and the other "momentum stocks" and how these drops will leave the stock market catapulting higher
9. please explain why the aaii sentiment survey at 55% bullish is suddenly not a "contrarian indicator" after all of these years and proven historical data of that relationship
10. please explain why the central banks will not have to pay back the trillions they have printed globally to contain inflation in 2014 - and why the market will not react badly to that huge sucking sound as liquidity is withdrawn from the global financial system
11. please explain why the greeks fired live rounds at the german embassy yesterday and how this bodes well for the EU in 2014
12. please explain how the growing geopolitical risk will be contained as the wealth divide worsens in 2014
tell you what, work on these minor quiz questions and then i'll then give you the main test ....
and no, i am not predicting a downturn - just saying that those predicting a further substantial upturn from here is just a wee tad pollyannaish ... we'll see ... be safe out there ...
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.
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...
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.
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.
Copyright © 2014 Microsoft. All rights reserved.
The company complains after the son of Florida State's football coach is televised wearing -- gasp -- Under Armour.
VIDEO ON MSN MONEY
Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.
Contributors include professional investors and journalists affiliated with MSN Money.
Follow us on Twitter @topstocksmsn.