The 3 Forces Behind a Market Crash

There have been a lot of new highs reached in the market over the past few weeks and months, continuing most spectacularly yesterday. All-time highs have now been reached whether your scoring system is the famous Dow Jones Industrial Average, a broader large-cap index like the Russell 1000 (AMEX:IWB) or S&P 500, a mid-cap index like the S&P Midcap 400 Index (AMEX:IJH), or a smaller-cap index like the S&P SmallCap 600 or Russell 2000.

And so there has been much generally bandied about regarding whether the market is due, almost due, or past due for a crash. What's been going on in the market the past couple of days has added additional fuel to the fire. Because if there are sound reasons to fear a market crash, then it's time to come up with a decent alternative to sinking new money into the market.

Indications of a coming crash
Back in 1934, Benjamin Graham -- the father, grandfather, founder, and creator of securities analysis -- wrote that there are three forces behind a market crash.

1. The manipulation of stocks.
2. The lending of money to buy stocks.
3. Excessive optimism.

Let's assess the level of each today.

1. The manipulation of stocks
Graham was quite familiar with this factor, having played a key role in the market crash of 1929. There was, prior to the creation of the SEC in 1934, very little regulation of the markets by the federal government -- and what little existed was patently ineffective.

Things have markedly improved since then. However, because of the vast amounts of money made quickly at the end of the past decade, various manipulations of the market were more or less being taken for granted by those who followed the market closely. These included broad manipulation of the IPO market and the trading of favorable research reports for investment banking work by Wall Street's top (and middle and bottom) analysts, to name but two of the contributing factors to the crash of 2000 to 2002.

Today, however, there is far less potential for manipulation of the market. A better-staffed SEC, new regulations on the books including Reg AC (requiring a greater level of disclosure by analysts), the structure of IPOs, as well as Sarbanes-Oxley (expensive, but effective) mean that whatever manipulation is going on today is largely relegated to micro caps.

2. Lending money to buy stocks
Excessive use of margin contributed to the market collapse in the early part of this decade, and was a main culprit in 1929. Back then, an investor only had to have 10% equity and 90% margin to buy stocks. Low interest rates also led to excessive lending over the past few years in the housing market -- and were a contributing factor to the tech bubble of several years ago.

I have to admit that this factor is somewhat troubling today. According to a recent Barron's article, there is a higher level of margin debt for the NYSE and Nasdaq today than at any previous time -- $303 billion -- just slightly higher than the peak of $300 billion set in March 2000; though, factoring in inflation, it's not setting any records. I'd keep an eye on this factor, but I'd measure its effect through the lens of the third factor.

3. Excessive optimism
According to current price-to-earnings (P/E) multiples, the most downcast curmudgeon simply can't argue that today's prices reflect excessive optimism.

Stocks are squarely in the range of normal P/E multiples -- while continuing (at least this past quarter) to realize earnings growth that is higher than the historical average. Moreover, these companies sport record amounts of cash on the balance sheets and continue to increase their reserves even as they repurchase shares, pay dividends, or both.

For a quick comparison of what "excessive optimism" looks like, observe some of the multiples of prominent stocks from the era of "irrational exuberance."

Further evidence of the zeitgeist of the period can be seen by reading what prominent financial publications were tagging as sure-fire stocks. Today, though, the market as a whole is trading around 17 times earnings, comfortably within the range of the historical average. Indeed, in comparison with interest rates (the Fed model), today's earnings yield points to fair to underpriced securities, though with the bond yield moving up over the past couple of days, that has narrowed. You cannot bend, fold, spindle, or mutilate these figures to arrive at the conclusion that there is rampant excessive optimism built into today's domestic stock prices. Foreign emerging markets? Yes, perhaps there, but not here.

The Foolish bottom line
While earnings growth could slow, given the strength of balance sheets and the proclivity of companies to buy back their own shares right now, continued earnings-per-share growth looks like a good bet for a while.

So now appears to be a good time, even at new highs, for staying in the market. Motley Fool Stock Advisor is staying fully invested, a strategy that has helped us produce returns of 76% versus 38% for the S&P over the past five years. Enjoy a free 30-day no-risk guest pass to our service, including coverage of more than 60 stocks, by clicking here.

This article was originally published on Feb. 15, 2007. It has been updated.

Bill Barker does not own shares of any company mentioned in this article. Microsoft is an Inside Value recommendation. Johnson & Johnson is an Income Investor pick. The Motley Fool has a disclosure policy.