In less than a week, we'll officially be ringing in a new year. However, Wall Street might be sad to see 2021 come to a close. The benchmark S&P 500 (^GSPC 0.89%) has more than doubled up (+24%) its average annual total return of 11% (including dividends) over the past four decades, and it hasn't undergone a steeper correction than 5%. It's been a true running of the bulls.
But as we turn the page on 2021, it's quite possible Wall Street could lose its luster. Below are seven reasons the stock market could crash in January.
1. Omicron supply chain issues (domestic and abroad)
The most obvious obstacle for the S&P 500 is the ongoing spread of coronavirus variants, of which omicron is now the most predominant in the United States. The issue is that there's no unified global approach as to how best to curtail omicron. Whereas some countries are now mandating vaccines, others are imposing few restrictions, if any.
With a wide variance of mitigation measures being deployed, the single greatest risk to Wall Street is continued or brand-new supply chain issues. From tech and consumer goods to industrial companies, most sectors are at risk of operating shortfalls if global logistics continue to be tied into knots by the pandemic.
2. QE winding down
Another fairly obvious high-risk factor for Wall Street is the Federal Reserve going on the offensive against inflation. As a reminder, the Consumer Price Index for all Urban Consumers (CPI-U) rose 6.8% in November, which marked a 39-year high for inflation.
Earlier this month, Federal Reserve Chairman Jerome Powell announced that the nation's central bank would expedite the winding down of its quantitative easing (QE) program. QE is the umbrella program responsible for buying long-term Treasury bonds (buying T-bonds pushes up their price and weighs down long-term yields) and mortgage-backed securities.
Reduced bond buying should equate to higher borrowing rates, which in turn can slow the growth potential of previously fast-paced stocks.
3. Margin calls
Wall Street should also be deeply concerned about rapidly rising levels of margin debt, which is the amount of money that's been borrowed by institutions or investors with interest to purchase or short-sell securities.
Over time, it's perfectly normal for the nominal amount of outstanding margin debt to climb. But since the March 2020 low, the amount of outstanding margin debt has come close to doubling, and now sits at nearly $919 billion, according to November data from the independent Financial Industry Regulatory Authority.
There have only been three instances in the last 26 years where margin debt outstanding rose by at least 60% in a single year. It happened just months before the dot-com bubble burst, almost immediately ahead of the financial crisis, and in 2021. If stocks drift lower to begin the year, a margin-call wave could really accelerate things to the downside.
4. Sector rotation
Sometimes, the stock market dives for purely benign reasons. One such possibility is if we witness sector rotation in January. Sector rotation refers to investors moving money from one sector of the market to another.
On the surface, you'd think a broad-based index like the S&P 500 wouldn't be fazed by sector rotation. But it's no secret that growth stocks in the technology and healthcare sectors have been primarily leading this rally from the March 2020 bear market bottom. Now that we're well past the one-year mark since this bottom, it wouldn't be all that surprising to see investors locking in some profits on companies with valuation premiums and migrating some of their cash to safer/value investments or dividend plays.
If investors do begin to choose value and dividends over growth stocks, there's little question the market-cap-weighted S&P 500 will find itself under pressure.
5. Meme stock reversion
A fifth reason the stock market could crash in January is the potential for a dive in meme stocks, such as AMC Entertainment Holdings and GameStop.
Even though these are grossly overvalued companies that have become detached from their respectively poor operating performances, the Fed noted in its semiannual Financial Stability Report that near- and long-term risks exist with the way young and novice investors have been putting their money to work.
In particular, the report highlights that households invested in these social-media-driven stocks tend to have more-leveraged balance sheets. If common sense prevails and these bubble-like stocks begin to deflate, these leveraged investors may have no choice but to retreat, leading to increased market volatility.
Even though valuation is rarely ever enough, by itself, to send the S&P 500 screaming lower, historic precedents do suggest Wall Street may be in trouble come January.
As of the closing bell on Dec. 21, the S&P 500's Shiller price-to-earnings (P/E) ratio was 39. The Shiller P/E takes into account inflation-adjusted earnings over the past 10 years. Though the Shiller P/E multiple for the S&P 500 has risen a bit since the advent of the internet in the mid-1990s, the current Shiller P/E is more than double its 151-year average of 16.9.
What's far more worrisome is that the S&P 500 has declined at least 20% in each of the previous four instances when the Shiller P/E surpassed 30. Wall Street simply doesn't have a good track record of supporting extreme valuations for long periods of time.
7. History makes its presence felt
Lastly, investors can look to history as another reason to be concerned about the broader market.
Since 1960, there have been nine bear market declines (20% or more) for the S&P 500. Following each of the previous eight bear market bottoms (i.e., not including the coronavirus crash), the S&P 500 underwent either one or two double-digit percentage declines in the subsequent 36 months. We're now 21 months removed from the March 2020 bear market low and haven't come close to a double-digit correction in the broad-market index.
Keep in mind that if a stock market crash or correction does occur in January, it would represent a fantastic buying opportunity for long-term investors. Just be aware that crashes and corrections are the price of admission to one of the world's greatest wealth creators.