Is a Crash Coming?

Following the creed of "buy when there's blood in the streets," you'd think now would be a great time to jump into the market. When you look at many stocks that have been unfairly punished, it is. But from a broader perspective, the Royal Bank of Scotland has a much more dire view: The worst is yet to come, the bank says, and it's lurking just around the corner.

Let's get ready to rumble
RBS, one of the largest and most respected banks in the world, issued a report predicting that the S&P 500 average will tumble 300 points, or more than 20% at today's levels, by September. This September! That's three months away. Yikes! Such a drastic move isn't a pullback, a correction, or a dip ... it's an all-out crash. So, is RBS right, or is this just a contrarian indicator that we've finally reached a bottom?

Claims of an abrupt move of that magnitude are sure to draw a few "give-me-a-break" stares. Overreaction in times of uncertainty is nothing new: Y2K quickly comes to mind. At first glance, it's tempting to brush aside such doomsday scenarios as nothing but financial paranoia. At the risk of eating my own words three months from now, I won't go as far as saying a 20% crash is impossible, but there are several arguments for why it's highly unlikely.

Here are a few.

Nice timing
People who try to predict what the market will do over a three-month period are sticking their necks out pretty far. You could have observed that Yahoo! (Nasdaq: YHOO  ) and Amazon.com (Nasdaq: AMZN  ) were grossly overvalued in 1998, and by most definitions, you were right. But just because your analysis was right, that didn't stop the market from another two-year rally. As John Maynard Keynes once said, "The market can stay irrational longer than you can stay solvent."

Analyzing that something is overvalued or undervalued is one thing; predicting when exactly it'll move is a whole different ball game. A 20% drop over the next year or two ... that would be a different story. But for something like that to happen within a three-month stretch would probably require specific catalysts beyond RBS's specified combination of credit-market and inflationary meltdown.  

A lot is already baked in
The bulk of companies that got in the most trouble over the past few years -- subprime lenders, overextended investment banks, and optimistic homebuilders -- are either bankrupt or close to it. Sure, it wouldn't be too startling to see financial players such as Washington Mutual (NYSE: WM  ) and Bank of America (NYSE: BAC  ) get bucked around from more credit-market pain, but on average, the S&P 500 is still filled with plenty of companies that (a) do a huge chunk of business outside the U.S. and (b) don't rely on a vibrant debt market.

From energy titans like ExxonMobil (NYSE: XOM  ) to multinational tech giants like Microsoft (Nasdaq: MSFT  ) , there's still a hefty subset of the S&P 500 that is doing quite well. For the entire index to fall 20% would mean either companies that are still doing well will tank, or the ones that aren't will be virtually wiped out -- and both outcomes seem pretty extreme at best.

It's really not that bad
OK, it is that bad, but hear me out. Think about this: One of our major investment banks has crumbled, our largest mortgage lender is shot to pieces, the price of oil has practically doubled over the past year, consumer confidence is at an all-time low, real estate is undergoing its largest correction in recent memory, and unemployment is rising -- and nonetheless, the Dow Jones Industrial Average trades at virtually the same level it did in the fall of 2006, when times were "good."

You could take that a couple of ways. You could say the market is grossly overvalued and waiting for a massive crash, or you could say the economy is more flexible and forgiving than most people presume. Truth be told, I think it's probably a little of both, but focusing on the first without giving weight to the second can cause you to make skewed predictions about the future.

Crashes have happened in the past, and they'll happen in the future. That isn't a question. But the famous crashes we lived through in 1929, 1987, and 2000 were caused by forces that aren't anywhere to be seen today -- specifically, blatant overvaluation. Only time will tell whether the next three months turn out to be as grim as predicted, but this Fool isn't counting on it.

Clock's ticking, RBS.

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Bank of America is a Motley Fool Income Investor selection. Microsoft is a Motley Fool Inside Value pick. Amazon.com is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. He welcomes your feedback. The Fool has a disclosure policy.


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  • Report this Comment On June 27, 2008, at 1:03 AM, RRTRACKS wrote:

    This was an excellent article as far as it went; however, there are a number of concerns and questions about the effect of a number of items that could have been discussed a little more fully.

    The price of oil doubling in the past year is going to have a significant impact on consumer spending on two fronts. The gas tank is going to take money out of consumers’ pockets at a rate versus income much higher than has been seen in the past. As the price of food is largely tied to energy, a second hit is going to be taken there as well. I do not recall ever seeing a model affecting consumers’ pocketbooks versus income to this degree in the past. Am I mistaken?

    Declining real estate values coupled with a tighter credit market over time is going to take money added to the economy from refinancing. Just what did all these people in financial sector losing their jobs do? There is a pretty good chance a great many of them moved money, outside of new construction and mortgages, back into the economy one way or the other. Is this true or false and to what degree?

    Stating the U.S. economy has a great deal of inertia because of its size would probably be an accurate statement. For each known and unknown factor driving the economy down there may be several other unknown factors bringing it up. Where the balance between the two and the delay between the imbalances, is going to have an effect while the balance is changing, has been something people have not been able to accurately predict.

    The good news from the negative slant given on the economic outlook from the comments presented here is the fact I do not know anything about either finance or economics. Maybe the author in a future article or people reading here could provide a response to the opinions and questions presented.

    Thanks,

    Rich

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