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Investor Beware: These 4 Economic Trends Could Cause a Market Crash in 2020

By Keith Noonan - Feb 2, 2020 at 12:21PM

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These dynamics could put an end to the market's record bull run.

The U.S. closed out the last decade with a record period of economic expansion, marking the first time in the country's history that the economy went 10 years without recording a gross domestic product (GDP) decline in two successive quarters. The stock market has been on a tremendous bull run that dates back to March 9, 2009, with the S&P 500 index rising nearly 392% across the stretch, and the dividend-adjusted total return for the SPDR S&P 500 ETF coming in at roughly 509%. Major stock market indexes like the S&P, the Nasdaq, and the Dow all trade near record highs.

The American economy continues to look strong early in 2020, but an eventual slip into recession is a question of when -- and not if. A recent poll conducted by Fortune found that 58% of investors thought that a recession was likely to occur this year. On the other hand, just 5% of respondents thought that the stock market would decline in 2020. That disparity evidences a worrying disconnect -- it might even be described as "irrational exuberance." 

There are indicators suggesting that the current period of record U.S. economic expansion will continue through this year and help prolong the stock market's bull run. However, the economy could avoid posting two successive quarters of declining GDP that mark a recession and still see a market crash. In addition to world events like the coronavirus outbreak and an upcoming U.S. presidential election that's poised to be highly contentious, investors should be aware that the following four economic factors could help create the conditions for a substantial stock sell-off in 2020.  

A chart arrow moving down and to the right.

Image source: Getty Images.

1. Earnings growth is soft on the surface and concerning under scrutiny

Stock market performance this year can be expected to have a close relationship with earnings growth. Shareholders want to see that companies are expanding their profits because this paves the way for the earnings generated to match the share price at the time of investment faster and propels valuations higher. According to research from Refinitiv, corporate earnings climbed 22.7% in 2018 following the Tax Cuts and Jobs Act that was passed in the previous year, but earnings growth was much more muted in 2019 -- coming in at an estimated 1.1%.

Other estimates suggest that earnings actually decreased in 2019. As my colleague Sean Williams recently pointed out, analysis from Factset Research suggests that earnings for S&P 500 companies fell in each quarter last year. With the index growing roughly 29% last year and no meaningful increase in net income, that's something that investors should be paying close attention to and thinking about this year. 

Earnings momentum is projected to be stronger in 2020, with Refinitiv laying out a 9.6% annual growth target, analysis from Goldman Sachs projecting an increase somewhere in the neighborhood of 6%, and the average analyst target modeling for 4.7% growth. However, if earnings for S&P 500 companies grow in 2020, it's likely that buybacks will be a driving factor in the gains. The issue there is that buybacks don't do anything to directly strengthen the underlying businesses.

As noted by the Harvard Business Review, only 47% of companies in the S&P 500 listed any research and development expenses in 2018 -- and 38 companies accounted for 75% of total R&D spending. Some of that disparity can be explained by large, mature companies having less incentive to spend on the category and industries like technology being heavily dependent on it, but there are signs that businesses aren't spending enough on initiatives that power revenue-driven earnings growth. At the same time, margins also slipped over the last year due to factors including rising labor and materials costs.

Factset's data as of Jan. 24 shows the market trading at a 12-month forward earnings multiple of 18.6. That multiple is significantly above both the five-year average forward P/E of 16.7 and 10-year average of 14.9. With the potential for relatively weak, buyback-driven earnings growth in 2020, that sets up a dynamic that could prompt weakness in the market this year or at some further point in the not-too-distant future.

2. Stock buybacks are slowing down

The 2017 Tax Cuts and Jobs Act lowered the top corporate tax rate from 35% to a flat rate of 21% and kicked off a huge stock buyback push that has powered the market's gains over the last three years. The reduced corporate tax rate resulted in a new influx of cash being funneled into share-repurchase programs, and provisions in the bill also allowed companies to repatriate money held in non-domestic bank accounts at a significantly lower tax rate.

Many companies that transferred large overseas cash holdings back to the U.S. opted to pass some of these funds along to shareholders in the form of stock buybacks and dividends. When a company buys back shares from stockholders, it typically retires them -- meaning that there are fewer total shares outstanding and overall earnings per share are elevated as a result. This major growth catalyst has started to slow and will likely be further weakened this year.

A bull and a bear made out of papers displaying chart lines.

Image source: Getty Images.

Stock buybacks hit roughly $835 billion in 2018, dipped 15% in 2019 to $710 billion, and are projected to fall another 5% in 2020, according to research from Goldman Sachs. The decline in share repurchases (when viewed in conjunction with other factors such as a projected decline for capital spending) signals that fewer companies are viewing their shares as undervalued. While a 5% decline this year doesn't look like cause for alarm, Goldman is concerned that a bigger drop for buybacks could result in significant market volatility. 

Corporate buybacks have been a driving force in the market's rally, and current models show that catalyst weakening this year. If potential conditions such as weaker-than-expected performance in key economies or another turn for the worse in the U.S.-China trade war saga were to occur, the drawdown on share repurchases could come in significantly worse than Goldman's most recent projection -- heightening the potential for a market crash. 

3. Corporate debt is at record levels and climbing higher

According to the Washington Post, U.S. corporate debt hit nearly $10 trillion at the end of 2019 -- a figure that represented roughly 47% of GDP for the year. That's been facilitated by low Fed interest rates and other central banks and a weak bond market.

Low interest rates mean that retail investors can take advantage of cheap loans, and this can have the unfortunate effect of prompting them to pursue risky investments. The same is true for corporations issuing bonds or otherwise using debt to buy back their own stock or invest in other companies. 

What's worse, much of the big buyback push has been dependent on debt being used to repurchase the shares. According to Goldman Sachs, 2019 saw the amount that corporations returned to shareholders in the form of buybacks and dividends exceed free cash flow for the first time since 2007 -- with dividend and buyback spending coming in at 104% of total cash flow in the twelve-month period ending in March.

Taking on debt in order to fund buybacks isn't always a bad move. If the underlying business is sound and there's a strong case to be made based on the fundamentals and growth prospects, it's a move that can wind up working out very well for a company and its shareholders. That's hardly the case for every company that has taken this avenue in recent years, and big names like Boeing and Bed Bath & Beyond spring to mind as examples of companies that have squandered billions in value on buybacks and now have much bigger debt and liquidity problems to show for it.

Even if the majority of management teams using debt to fund substantial buyback initiatives can be said to have made prudent moves, the record level of corporate debt combined with too many poorly conceived share-repurchasing programs could weaken the broader market. 

4. Key international economies showing signs of weakness

The U.S. economy has been posting strong performance, beating expectations in 2019 and showing signs of strength early this year. Goldman expects annual GDP growth of 2.3% in 2020, and U.S. National Economic Council director Larry Kudlow recently forecast that the economy will post a growth rate above 3%. That would seem to bode well for stock market performance. However, most U.S. companies now have substantial exposure to international markets, and slowdown in key territories could create a meaningful drag on performance for stocks. 

A miniature globe on top of different currencies.

Image source: Getty Images.

German GDP shrank 0.1% in the second quarter of 2019 and grew 0.1% in the third quarter, according to the company's Federal Statistics Office, just barely dodging recession. Germany's Federal Statistics Office reported full-year growth of 0.6%, marking the 10th year of economic expansion in the country. However, the full-year expansion was also significantly below the level of government-and-analyst forecasts from earlier in the year and represented the country's weakest growth since 2013. Better-than-expected consumer spending helped Germany avoid entering recession, but with the country's industrial production already in a period of decline, the consumer retail market could soon feel more pressure.

Germany is Europe's largest economy, and the country's performance both affects other countries in the region and functions as a bellwether for the continent's overall macroeconomic environment. Performance for the French economy in the third quarter surpassed expectations, but still grew at a meager 0.3%. Meanwhile, Moody's forecasts that GDP growth in Britain will slow to just 1% in 2020, down from its estimate for 1.2% growth in 2019. 

Key economies outside of Europe are slowing, as well. The International Monetary Fund recently cut India's GDP growth forecast for 2020 to 4.8%, a substantial reduction from the 6.1% annual growth target that it laid out in October. Meanwhile, China posted its lowest economic growth in 29 years with a 6.1% GDP expansion in 2019 -- and many sections of the country's manufacturing industry saw steep year-over-year declines. Growth for consumer spending has been powering the Chinese economy in recent years, but substantial slowdown for the country's industrial sector casts a shadow over the consumer outlook. Signs of weakness are already evident in slowdown for smartphone and automobile sales, which both fell 8% year over year in December according to Nikkei. 

China, which has the world's second-largest economy behind the U.S., was broadly projected to grow somewhere in the 6% range in 2020, but developments early in the year suggest that it could miss that target. With many businesses, schools, and transportation centers in urban hubs near the outbreak of the coronavirus in Wuhan shutting down and indications from the country's government that the spread of the virus is accelerating, the outbreak could have a significant effect on China's economy. 

The overall picture is that the global economic performance is showing some signs of weakness, even as things are generally looking pretty good in the U.S. right now. The American market doesn't exist in a vacuum, however. A major European economy like Germany slipping into recession or a more turbulent business climate in China could cause investors to reevaluate the global economic picture, kicking off a reduction in confidence in markets that leads to a substantial sell-off for stocks. 

What should investors do to prepare for the next crash?

Timing when a market crash will occur is incredibly difficult, and history has shown that it's almost impossible to do with any meaningful degree of consistency. At the same time, a correction will happen eventually, and prudent investors should be looking at the market's record run in the context of previous trends and what appears to be a mounting set of risk factors.

That doesn't mean that investors should panic and dump all their holdings. History has also shown that investors are better served by remaining in the market instead of trying to predict its highs and lows, but those concerned that the bull run has reached a late stage may want to shift their holdings toward high-quality defensive stocks. Reducing positions in speculatively valued, growth-dependent companies and increasing positions in resilient, dividend-paying stocks can be a way to prepare for potential volatility while still staying engaged in the market.

The long-term trajectory is that the market will continue to rise, and even highly growth-dependent stocks should emerge from a crash and go on to reach new heights if the underlying business is strong. With the bull market approaching the 11-year mark, investors should feel good about the record run and evaluate their holdings to determine if a shift toward more defensive stocks is in line with their risk tolerance.

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Stocks Mentioned

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Bed Bath & Beyond Inc.
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