Is the Stock Market Going to Crash Again?

With the market rallying over 40% from its March trough, investors are left scratching their heads for a suitable explanation, and even more so, a reliable path forward. 

From the economic perspective, we observe metrics that range from mass unemployment to record low consumer confidence: all of which point to clearly weakening fundamentals.

To make matters worse, the corporate counterpart isn’t any prettier. Earnings have been substantially revised down and businesses are struggling for cash, thus painting a fairly bleak picture for the stock market’s near future.

When looking at the disparity between the weak fundamentals outlined above and the current (rising) performance of stocks, cause for concern seems like a plausible mindset to uphold. How could this rally possibly be sustained?

Nevertheless, for those readers who are still positive that this rally will continue, here are 3 reasons why you could be wrong, and why a turbulent market lies ahead instead.

1. The wealthy are waiting

According to a survey by UBS, a majority of wealthy retail investors – individuals with over $1 million in investable assets – are sitting on the sidelines and letting the excited, pugnacious traders feed on this rally instead.

The investment bank found that over 61% of such wealthy investors are saving their cash (or deploying into money-market funds which can be liquidated easily), in hopes that stocks fall another 5-20% before they put their money to work again.

Figure 1: Wealthy investors increasingly staying in cash

(Source: Bloomberg)

The figure above becomes even more significant - and frankly unsettling - when considering the following statistic: If 38% of the stock market is made of retail investors, and 61% of these profit-seekers aren’t even in stocks at the moment (as shown above)…how is such a strong rally substantiated? 

The answer is, it probably shouldn't be.

Whilst more evidence lies ahead, the data here is the first fundamental/structural break that begins to whisper a need for caution.

2. Central banks are not invincible 

The Federal Reserve (and other central banks) are a large part of why this market is rallying, given that they've provided trillions of dollars in aid, opened more credit lines, and kept afloat near-bankrupt companies (from their investments into high-yield/junk bonds).

Seems like a fairly good set of strategies? At face value, maybe. Digging slightly deeper, maybe not.

Even though the Fed’s actions here are a positive autobahn for businesses, initial optimism may wither when we consider the following notion.

Because of the frequency and magnitude of the Fed’s intervention, the market has now “priced in” the idea that central banks are going to pursue whatever it takes – whenever it’s needed – to prevent asset prices from falling.

In other words, central banks' continuous support has conditioned markets into believing that they will indefinitely stop any downward pressure on prices: therefore causing investors to feel more comfortable when adding risk to their portfolio.

Figure 2: Current prices (blue) staying afloat despite future earnings revised downward (yellow) 

This almost acts as an insurance policy when buying stocks: why wouldn’t we begin putting our money to work if we know prices will be protected?

A valid argument, but are prices really as protected as we think...

Howard Marks of Oaktree Capital proclaimed that 15-25% of the Fed’s high yield/junk bond investments – essentially bonds that are deemed as very risky and usually belong to fundamentally poor companies – will default. This means that the central bank is likely to lose over $400 billion from one investment, therefore giving rise to two questions:

Both of these possibilities suggest that the comfortability of betting on moral hazard (the idea that the Fed will intervene no matter what) will begin to wane, and fundamental analysis may begin to drive sentiment once again.

Unfortunately, if this change in mindset occurs, we could see another market crash caused by:

3. Highly overvalued market

Alongside wealthy individuals sitting on the sidelines, another indicator of trouble is the fact that even hedge funds and asset managers are joining in on the caution: citing that this market is far too overvalued given the poor future outlook. 

A visual indicator of this issue is given below, showing that equities have not been this pricey since the early 2000s:

Figure 3: Valuation of stocks over time (price of 1 share divided by earnings)

Source: (Bloomberg, 2020)

While such valuations would be acceptable – not desirable, but acceptable – in normal scenarios, they become unsettling when we consider how bleak the near future of economies and markets are.

Job losses, business cash struggles, and lower economic activity are all issues that are still prevalent and likely to continue in the coming months: leading us to once more question the sustainability of this market rise.

What happens when investors realize that the recovery - both economic and financial - may be more difficult than it seems?

“It is entirely possible that there will be a fourth-quarter reckoning, where a second wave of job losses and a prolonged period of business failures will test equity sentiment” - Seema Shah, chief strategist at Principal Global Investors. 

Funds have begun taking measures to shield themselves from such reckonings, by moving towards cash, using put options (selling at a fixed price to protect downside), and even going short (betting against) certain indexes. While we may not need to delve into such technical strategies, retail investors – such as you and I – can focus on usual hedges such as Gold, Japanese yen, and even sitting on cash waiting for better opportunities.

 Despite stocks usually being the most rewarding path to take, the current disproportion between stock prices and fundamentals screams caution. As Bryce Elder of the Financial Times quite brilliantly put it:

“Anyone lucky enough to have caught [the market rise] should probably take their money now and run”.

This article was first published on my personal blog https://www.thedividendpayout.com/.