The 3 Forces Behind a Market Crash

There were a lot of new highs reached in the market a few weeks ago -- followed by very significant declines over the past couple of weeks. These were all-time highs if your scoring system is the Dow Jones Industrial Average (AMEX:DIA), or the S&P 500 (AMEX:SPY), and since then we've seen reversals of all indexes in the 6% range.

And so there has been much generally bandied about regarding whether the market is ready for -- or already in the midst of -- a crash. 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 a market that may just appear to be a little bit cheap.

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 that 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 when 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 a couple years ago.

I'd have to admit that this factor is somewhat troubling today. According to a recent Barron's, there is a higher level of margin debt for the New York Stock Exchange and Nasdaq this year than at any previous time -- $303 billion, just slightly higher than at the peak of $300 billion set in March 2000. I'd keep an eye on this factor, but I'd measure its effect through the lens of the third factor.

3. Excessive optimism.
At least as reflected in current price-to-earnings ratios (P/Es), the most downcast curmudgeon simply can't ague that today's prices reflect excessive optimism.

Stocks are squarely in the range of normal P/Es -- while continuing this quarter to realize significantly higher than historically average earnings growth. 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 (link opens Excel file) is trading at 16 to 17 times earnings, comfortably within the range of the historical average. Indeed, in comparison to interest rates (the Fed model), today's earnings yield points to underpriced securities. 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 -- but not here.

The Foolish bottom line
While it is the case that 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 this appears to be a good time, even at new highs, to stay in the market. Motley Fool Stock Advisor is staying fully invested, which is the strategy that has helped us produce returns of 67% versus 29% 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 first published Feb. 15, 2007. It has been updated.

Bill Barker does not own shares of any company mentioned. Dell and Yahoo! are Motley Fool Stock Advisor recommendations. Dell, Intel, and Home Depot are Inside Value picks. The Motley Fool has a disclosure policy.