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This Is What a Recipe for a Stock Market Crash Looks Like

By Sean Williams - Mar 20, 2021 at 5:51AM

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A big move lower may be in the offing for the Nasdaq and S&P 500, but that's not necessarily bad news for long-term investors.

What a difference a year can make. At this time last year, uncertainties surrounding the coronavirus had fully gripped the stock market. All three of the major U.S. indexes were in free fall, with the widely followed S&P 500 (^GSPC 2.47%) ultimately losing over a third of its value in roughly one month's time.

But since hitting a bear market bottom on March 23, 2020, it's been pedal to the metal for equities. The tech-heavy Nasdaq Composite (^IXIC 3.33%) more than doubled off of its lows, while the benchmark S&P 500 has gained 77% (through March 13, 2021).

Unfortunately, this young bull market run that investors have been privy to may be shorter-lived than expected.

Although there's no concrete recipe for a stock market crash, the two most promising ingredients to cause the indexes to plunge are currently both in place. This doesn't guarantee that a crash is imminent, but given the history of plunges associated with the S&P 500, a big move lower can't be discounted.

A twenty dollar bill paper airplane that's crashed and crumpled into a financial newspaper.

Image source: Getty Images.

Is this the perfect recipe for a stock market crash?

I know what you might be thinking, and no, rising Treasury bond yields aren't one of the two telltale signs that a crash could be coming. The concern behind rising yields is that it could signal higher levels of inflation.

A big uptick in inflation might coerce the Federal Reserve to raise rates sooner than 2024. This would make borrowing more expensive and weigh on the growth stocks that have carried the Nasdaq Composite and S&P 500 higher. Additionally, higher yields could chase conservative investors out of stocks and back into bonds.

The thing is, higher yields are also indicative of a rebounding U.S. economy. Equity valuations can't reasonably expand without there being signs of economic recovery. Pretty much every bounce-back from recession we've witnessed over the past five decades has involved an uptick in Treasury bond yields. In many instances, the S&P 500 rises right along with bond yields.

Rather, the recipe for a stock market crash involves premium equity valuations mixed in with a hearty helping of investor leverage.

An accountant chewing on a pencil while closely examining figures from his printing calculator.

Image source: Getty Images.

History says a premium valuation in the S&P 500 leads to a 20% (or greater) decline

Though great businesses often command premium valuations, history has conclusively shown that a premium earnings multiple for the S&P 500 eventually leads to significant downside in the index. As of the close of business on March 13, the S&P 500's Shiller price-to-earnings (P/E) ratio was 35.65.

The Shiller P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. This reading of nearly 35.7 is well over double its average reading of 16.8 over the last 150 years and is the second-highest reading of all time.

Of the previous four instances where the S&P 500's Shiller P/E ratio surpassed 30 and sustained that level during a bull market run, the index subsequently gave back between 20% and 89% of its value. Keep in mind that the 89% decline was registered during the Great Depression, and a drawdown of this magnitude would be highly unlikely in the modern era with the Federal Reserve and U.S. government willing to support equity markets with dovish monetary policy and fiscal stimulus. Nevertheless, a 20% decline from a bull market top has been the bare-minimum expectation when the Shiller P/E ratio surpasses and sustains above 30.

A businessman hiding a stack of cash behind his back, with his fingers crossed.

Image source: Getty Images.

Retail investor leverage has risen dramatically

The other necessary ingredient for a stock market crash is leverage -- and retail investors may be the key.

Where coronavirus uncertainty caused wild swings in equity valuations in 2020, this year's volatility can be attributed to retail investors on Reddit's WallStreetBets chatroom. Without getting too far into the weeds, these young and/or novice investors have agreed to work together to buy shares and out-of-the-money call options on heavily short-sold companies and/or penny stocks. In many instances, these retail investors have proved successful at driving the price of these targeted stocks higher.

But there's another side to this short-term success that can't be ignored.

Back in September, a Harris poll found that 43% of retail investors were using some form of leverage. The survey found that 10% of respondents bought securities on margin, 23% purchased options, and another 10% bought securities on margin and purchased options.

What this tells us is that young investors are attempting to time the market, and in some instances, they're using borrowed money in an attempt to compound their gains. When their short-term guesses prove incorrect -- which is only a matter of time -- retail investors' emotions and margin calls could quickly exacerbate downside moves in the major indexes.

A smiling young woman holding a financial newspaper while looking off into the distance.

Image source: Getty Images.

A crash begets opportunity

But there's good news, too.

Every single crash since the dawn of the U.S. stock market has proved to be a long-term buying opportunity. We may not know precisely when a stock market crash will occur, how long it'll last, or how steep the decline will be. However, we do know, unequivocally, that operating earnings growth drives equity valuations higher over time. Each of the S&P 500's and Nasdaq Composite's crashes and corrections throughout history have eventually been wiped away by a bull market rally.

Furthermore, stock market crashes and corrections have a way of working themselves out fairly quickly. Since the beginning of 1950, there have been 38 double-digit declines in the S&P 500. It took 104 or fewer calendar days (about 3.5 months) for 24 of these 38 drops to reach a bottom. Another seven crashes/corrections found their bottom between 157 calendar days (five months) and 288 calendar days (10 months).

While most corrections and crashes are measured in months or quarters, the typical bull market rally lasts years or perhaps even longer than a decade. The point is that it pays to be an optimist, even when stock market crashes are an inevitable part of the investing cycle.

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Stocks Mentioned

S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
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NASDAQ Composite Index (Price Return)
^IXIC
$12,131.13 (3.33%) $390.48

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