The 3 Forces Behind a Market Crash

Only six months ago, many of the market's averages were hitting all-time highs: the Dow Jones Industrial Average, other broad large-cap indices such as the Russell 1000 or S&P 500, mid-cap indices such as the S&P Midcap 400 Index, and smaller-cap indices such as the S&P SmallCap 600 and Russell 2000. But since then, market bulls have felt a lot of volatility and pain, continuing right through the end of the quarter just completed.

And so there has been much talk of whether the market is due, almost due, or past due for a "crash" -- which would be worse than what we have presently. If there are sound reasons to fear a market crash, then it's time to come up with a decent alternative to sinking new money into the market.

Indications of a coming crash
Back in 1934, Benjamin Graham -- the father, grandfather, founder, and creator of securities analysis -- wrote that there are three forces behind a market crash.

1. The manipulation of stocks
2. The lending of money to buy stocks
3. Excessive optimism.

Let's assess the level of each today.

1. The manipulation of stocks
Graham was quite familiar with this factor, having played a key role in the market crash of 1929. There was, prior to the creation of the SEC in 1934, very little regulation of the markets by the federal government -- and what little existed was patently ineffective.

Things have improved markedly since then. However, because of the vast amounts of money made quickly at the end of the past decade, various manipulations of the market were more or less being taken for granted by those that followed the market closely. These included broad manipulation of the IPO market and the trading of favorable research reports for investment banking work by Wall Street's top (and middle and bottom) analysts, to name but two of the contributing factors to the crash of 2000 to 2002.

Today, however, there is far less potential for market manipulation. A better-staffed SEC, new regulations on the books including Reg AC (requiring a greater level of disclosure by analysts), the structure of IPOs, as well as Sarbanes-Oxley (expensive, but effective), mean that whatever manipulation is going on today is largely relegated to micro caps.

2. Lending money to buy stocks
Excessive use of margin contributed to the market collapse in the early part of this decade, and was a main culprit in 1929. Back then, an investor only had to have 10% equity and 90% margin to buy stocks. Low interest rates also led to excessive lending in the past few years in the housing market -- and were a contributing factor to the tech bubble of a couple of years ago.

I have to admit that this factor is somewhat troubling today. The New York Stock Exchange is experiencing a level of margin debt that's nearly an all-time high -- $335 billion.

I'd keep an eye on this factor, but I'd measure its effect through the lens of the third factor.

3. Excessive optimism
According to current price-to-earnings (P/E) multiples, the most downcast curmudgeon simply can't argue that today's prices reflect excessive optimism.

Stocks are squarely in the range of normal P/E multiples. Moreover, these companies sport record amounts of cash on the balance sheets and continue to increase their reserves even as they repurchase shares, pay dividends, or both.

For a quick comparison of what "excessive optimism" looks like, observe some of the multiples of prominent stocks from the "Era of Irrational Exuberance."

Further evidence of the zeitgeist of the time can be seen by reading what prominent financial publications were tagging as surefire stocks.

Today, though, the market as a whole (link opens Excel file) is trading at 16 to 17 times operating earnings, comfortably within the range of the historical average. Indeed, in comparison to interest rates (the Fed model), today's earnings yield points to underpriced securities. You cannot bend, fold, spindle, or mutilate these figures to arrive at the conclusion that there is rampant excessive optimism built into today's domestic stock prices. Foreign emerging markets? Yes, perhaps there, but not here.

The Foolish bottom line
While earnings growth could slow, given the strength of balance sheets and the proclivity of companies to buy back their own shares right now, continued earnings-per-share growth looks like a good bet for a while.

So now appears to be a good time, even at new highs, for staying in the market. Motley Fool Stock Advisor is staying fully invested, a strategy that has helped us produce returns of 56% versus 19% for the S&P over the past six years.

You can enjoy a free, 30-day, no-risk guest pass to our service, including coverage of more than 60 stocks.

This article was originally published on Oct. 10, 2007. It has been updated.

Bill Barker owns shares of Home Depot, which is an Inside Value pick. The Motley Fool has a disclosure policy.