It's been a rough year in the stock market so far, and investors are worried that things are going to get worse. It's no time to panic, because fear can ruin your investment plan. However, now's a good time to assess the situation in the market and review your portfolio allocation to make sure you're ready for whatever comes next.
Some historical perspective
The short answer to the headline question is yes. The stock market has crashed numerous times in the past, and it's going to crash many more times in the future. Stock valuations rise and fall with supply and demand, and supply and demand are influenced by a variety of factors. Greed, fear, FOMO, and business outlook all play a role, as does the availability of other investments.
These factors can all change abruptly, and these changes can be triggered by a wide variety of events. Those include recessions, pandemics, wars, government fiscal crises, financial system failures, or shifts in monetary policy. It can also be a natural process of investors learning about new technology, such as the internet or blockchain.
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As a result, the market doesn't rise and fall smoothly with corporate profits. It moves through natural cycles that reflect the emotions and outlook of investors in aggregate. We can be sure that the market will crash again, but we can't always know exactly when.
Many investors have watched the damage done so far this year, and they're feeling fear that things will get worse from here. It's pure speculation as to what happens next, but we can look at some important data points as clues. If we know what's most likely to transpire in the stock market over the rest of the year, then we can prepare our investment plans accordingly.
Has the crash already happened?
The S&P 500 is down more than 12% so far this year, while the NASDAQ has plummeted 22% lower. A variety of things have contributed to the dip. Rising interest rates, weak earnings outlook, geopolitical fallout from the conflict in Ukraine, and worrisome economic data have all pushed the market lower. As a result, stocks are firmly in correction territory, and a bear market is in sight. People who were heavily weighted toward growth stocks and the tech sector are already experiencing a bear market, though equities as a whole haven't quite gotten there yet.
These dynamics are all influencing a larger overall trend. The market crashed in the first quarter of 2020 in response to the COVID-19 pandemic. Following that steep drop, investor risk appetite bounced back due to low interest rates, fiscal stimulus, and early signs that we were learning how to deal with the global health crisis. Capital flooded back into the stock market, especially into growth stocks and businesses that weren't disrupted by the pandemic.
These forces sent market valuations to levels that hadn't been seen since the dot com bubble. Stocks became very expensive relative to dividends, book value, cash flow, sales, and expected earnings. None of that was sustainable, and it was bound to revert back to historically normal levels eventually. Unfortunately, that reversion happened very quickly. High inflation forced the Fed to aggressively raise interest rates, which simultaneously made lower-risk assets more attractive and threatened growth.
While the market has responded to specific news, it's all occurring within the general trend of valuations returning to normal levels. That's the most important thing that will determine if the crash is behind us -- or if there's more to come.
Can the market fall even further?
Valuations in the stock market are definitely more rational than they were in December. That's removed a lot of downside risk. However, there are still signs that things could get worse from here. Interest rates will continue to climb to combat inflation. There's a chance that the Fed backs off its aggressive timeline if economic activity suffers too much, but rates are historically low -- they'll probably have to rise in the long term.
Economic activity appears to be slowing, and GDP (gross domestic product) fell in the first quarter. In first-quarter earnings reports, many corporate management teams spoke conservatively about their outlook for the full year. Low unemployment and strong wage growth might lose steam, and any pullback in the labor market will combine with high inflation to hurt consumer sentiment.
Clearly, much of the fuel for this market downturn remains. Valuations are getting close to pre-pandemic levels. Despite that, stocks aren't cheap from a historical perspective. If stocks were incredibly cheap relative to earnings, cash flows, or dividends, then it would create a floor for the market. Unfortunately, we're still far above that floor if these macroeconomic conditions continue.
Nothing is guaranteed at this point, but a steeper crash is absolutely on the table. There aren't any clear stock market catalysts on the horizon, and the current conditions likely aren't enough to prevent a bear market.
Investors should make sure that their portfolio is allocated to withstand volatility, but it's important not to panic and sell off all your stocks. There's still opportunity for long-term returns from here.
