The 3 Forces Behind a Market Crash

Only a few months ago, many of the market's averages were hitting all-time highs: the Dow Jones Industrial Average (as tracked by the Diamonds (AMEX: DIA) exchange-traded fund), other broad large-cap indices such as the Russell 1000 or S&P 500 (as tracked by the SPDRs (AMEX: SPY) ETF), mid-cap indices such as the S&P Midcap 400 Index, and smaller-cap indices such as the S&P SmallCap 600 and Russell 2000. But in the weeks and months since then, market bulls have felt a lot of volatility and pain, continuing right through today's market action.

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 had to have only 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 of years ago.

I'd have to admit that this factor is somewhat troubling today. According to a recent Forbes article, a record high of $381 billion in margin debt was recorded in July, and though it has declined to $322 billion recently, it is still higher than 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. Moreover, these companies sport record amounts of cash on their 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 to stay in the market. Motley Fool Stock Advisor is staying fully invested, which is the strategy that has helped us produce returns of 55% versus 16% 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. The Motley Fool owns shares of SPDRs. Dell, Amazon, and Yahoo! are Motley Fool Stock Advisor recommendations. Dell, Intel, and Home Depot are Inside Value picks. The Motley Fool has a disclosure policy.