When taken as a whole, it's been another great year for the stock market. Through Wednesday, Dec. 1, the benchmark S&P 500 (^GSPC 0.17%) was up 20% on a year-to-date basis. Considering that the widely followed index has averaged an 11% total return, including dividends, over the past 40 years, this is a solid performance.
However, the past week has been topsy-turvy for the stock market, with volatility retuning in a big way. We, as investors, may not like to think about stock market crashes and double-digit percentage corrections, but they're the price of admission to take part in one of the world's greatest wealth creators.
Right now, there are no shortage of catalysts that could send the S&P 500 over the edge for its first crash or correction since the pandemic began. Here are nine reasons the stock market could crash in the next three months.
1. Omicron/variant spread
Let's start with the obvious: the coronavirus and its growing number of variants.
This year, the S&P 500 has enjoyed more than five dozen record-high closes. The expectation has been that increasing U.S. and global vaccination rates would allow business to get back to normal. But with each new variant of COVID-19, the potential arises for additional lockdowns, restrictions, supply chain concerns, and a possible decrease in consumer or corporate spending.
For what it's worth, the delta variant's emergence in May led to a short-term market hiccup that was fairly quickly put in the rearview mirror. The same could be true for the omicron variant, but we simply don't know enough about it at the moment for Wall Street and investors to be confident buyers of stocks.
2. Historically high inflation
Some level of inflation (i.e., the rising price of goods and services) is expected in a growing economy. However, the 6.2% increase in the Consumer Price Index for All Urban Consumers in October marked a 31-year high.
The problem with inflation is that it has the potential to sap consumer and enterprise buying power. Even though wages are going up for workers, much of their buying power could be stripped away by rising rent/home costs, markedly higher energy prices, and even above-average food inflation.
If the next few inflation reports from the U.S. Bureau of Labor Statistics come in at or above 6% over the trailing 12-month period, the likelihood of this surge in prices being transitory starts going out the window. Wall Street won't like that one bit.
3. Energy price indigestion
Crude oil could also spell doom for Wall Street over the next three months.
In my view, crude is easily the most fickle commodity. If the price shoots too high, consumers and businesses either purchase less fuel or, if possible for businesses, pass along higher fuel costs to customers. On the other hand, if crude prices tank on fears of another variant, it can hurt job creation in the energy sector and even reduce overall confidence in the U.S. or global economy.
In other words, the oil market needs to provide some semblance of stability over these next three months. If the per-barrel price once again jumps above $80, inflation fears could dominate. Meanwhile, if it falls below $50, sectorwide investments could be curtailed.
4. Fed speak
The tone and actions of the Federal Reserve could also cause the stock market to crash over the next three months.
For much of the past decade, the nation's central bank has been extremely accommodative. This is to say that interest rates have been kept at or near historic lows, which has allowed growth stocks to borrow cheaply in order to hire, acquire, and innovate. Further, the Fed has fairly aggressively bought long-term Treasury bonds and mortgage-backed securities to encourage lending and confidence in the housing market.
But with inflation soaring, the Fed is going to have no choice but to eventually raise interest rates and begin slowing its bond-buying program. To put things mildly, investors have been spoiled with a long stretch of historically low lending rates. Any talk of a faster-than-expected rate hike could quickly sink the S&P 500.
5. A debt ceiling impasse
Keeping politics out of your portfolio is generally a smart move. But every once in a while, politics can't be swept under the rug.
We're currently less than two weeks away from the Dec. 15 deadline when the federal debt limit will be hit. If we reach the debt limit without a deal in Congress, the Treasury Department wouldn't be able to borrow. This means salaried federal employees may not get paid at a time when inflation is rising and the U.S. economy is still finding its legs following a wicked (but short) recession. It may even mean the U.S. defaulting on some of its debts, which could adversely affect its credit rating.
To be clear, this isn't the first rodeo for lawmakers when it comes to a debt-ceiling standoff. But the longer Congress waits to resolve things, the more likely it is the debt ceiling could weigh on equities.
6. Margin debt
Generally speaking, margin debt -- the amount of money borrowed from a broker with interest to purchase or short-sell securities -- is bad news. Although margin can multiply an investors' gains, it can also quickly magnify losses.
While it's perfectly normal to see nominal outstanding margin debt grow over time, the speed of its increase in 2021 is very alarming. As of October, almost $936 billion in margin debt was outstanding, according to the Financial Industry Regulatory Authority. That's more than doubled since the midpoint of the previous decade.
More importantly, margin debt rocketed higher by more than 70% earlier this year from the prior-year period. There have only been three instances since 1995 where margin debt surged over 60% in one year, according to analytics firm Yardeni Research. It happened just before the dot-com bubble burst, months prior to the financial crisis, and in 2021. That doesn't bode well for the stock market.
7. The unwinding of the meme-stock trade
Twice a year, the Federal Reserve releases its Financial Stability Report, which examines the resilience of the U.S. financial system and outlines some of the bigger near-term and longer-term risks worth monitoring. In the latest report, the nation's central bank examined the possibility that young investors putting their money to work in meme stocks like AMC Entertainment and GameStop could heighten volatility and disrupt the market.
The report points out that the younger investors involved in these trades "tend to have more leveraged household balance sheets." Losses in the market would leave these folks more vulnerable to meeting their debts. Plus, with these individual regularly buying options, risk is further magnified.
The Fed also notes that social media interactions, including the transmission of biased or unsubstantiated claims on message boards, could lead to increased volatility and a "potentially destabilizing outcome."
Valuation by itself is often not enough to send the stock market over the edge. But when market valuations reach historically high levels, it's an entirely different story.
On Dec. 1, the S&P 500's Shiller price-to-earnings (P/E) ratio was 38, and it had recently hit 40 for only the second time in 151 years. The Shiller P/E takes into account inflation-adjusted earnings over the past 10 years. For comparison, the average Shiller P/E for the S&P 500 dating back to 1870 is 16.89.
However, it's not how far above its historic average Shiller P/E that's worrying. It's that following the previous four instances where the Shiller P/E topped 30, the S&P 500 eventually went on to lose at least 20% of its value. When valuations get over-extended, as they are now, history has shown that crashes become commonplace.
9. Investors stick with history
A ninth and final reason the stock market could crash over the next three months is history. Specifically, if investors are of the belief that history repeats itself, the S&P 500 could be in trouble.
Dating back to 1960, there have been nine bear markets. Following each of the previous bear-market bottoms, excluding the coronavirus crash, we witnessed either one or two declines of at least 10% within 36 months. In other words, bouncing back from a bear market bottom is a process that often hits speed bumps.
But since the March 23, 2020 bottom, it's been an almost straight shot higher for the S&P 500. If Wall Street and investors were to bet on history repeating, they might lighten their portfolios in expectation of a double-digit percentage pullback or crash.