5 Reasons the Stock Market Won’t Crash–Yet
With the bull market now more than seven years old, many investors worry that a crash is imminent. Not so. Five reasons stocks still have room to run.
Is the stock market headed for another crash? Of course it is. The moment one crash ends, the market is always headed for another. But gains in the periods between crashes tend to last long enough to more than offset the periods of pain when crashes hit.
The current period of gain has lasted more than seven years and propelled the stock market averages to new highs. But since the peak of last May, the market has faltered, briefly touching double-digit lows early this year. Bears have begun to wonder whether the crash to which the market is always headed is just ahead.
Probably not. With rare exceptions, market crashes are accompanied by recessions, and the odds of recession are now quite low. So the crash that is always waiting to happen will probably have to wait a good bit longer. In fact, if economic growth accelerates from the sluggish pace of 2015, the bull market should resume, although probably at a modest, single-digit pace befitting its relatively advanced age.
Recessions involve a contraction in real gross domestic product, although not always in consecutive quarters. Exactly when they start and stop is left to the discretion of the economists on the Business Cycle Dating Committee, part of the private, nonprofit National Bureau of Economic Research. The NBER-determined recessions are marked by bars in the chart at right, which shows the last four, going back to 1981.
But what exactly is a market crash, a concept that has no official arbiters? For starters, it’s generally agreed that a bear market is defined as a decline on the market averages of 20% or more. But is a bear market always a market crash? When it lasts less than 12 months, we say no.
There was, for example, a 20% plunge in the Standard & Poor’s 500 index from late April 2011 through early October of that year. But in the months following, the market rebounded, and the index reached new high ground by January 2012. For indexing investors who held on for at least 12 months, there might have been single-digit losses, but nothing like 20%.
It therefore seems fair to require of any market crash worthy of the name that it show some persistence. As a measure of duration, 12 months seems a reasonable minimum. We define a market crash, then, as a decline of 20% or more on the Standard & Poor’s 500 that lasts at least 12 months.
By this definition, there has been just one market crash over the past 35 years that wasn’t accompanied by a recession: the 12-month decline of more than 20% from August 1987 through August 1988. Arithmetically, this crash would not have happened were it not for the largest one-day plunge in U.S. history: Black Monday, Oct. 19, 1987, when the market tumbled more than 20% in a single day, the only one-day bear market on record. The previous crash on a single day that was at all comparable ran in the low-double digits and occurred 58 years earlier, in October 1929.
And if a one-day crash does strike every 58 years, the next one is due 58 years from 1987, or in 2045. So if we treat the Black Monday–induced crash as an outlier, we are left with just three market crashes over the past 36 years plus one near crash, all four coinciding with the past four recessions.
As the chart shows, all four recessions were preceded by a stock market decline, with the decline becoming a crash, by our definition, once the recession began.
The first crash on the chart coincided with the major recession of 1981-82. The next recession, of 1990-91, sparked a near-crash, with the 12-month decline on the S&P index briefly running at negative 17% by September 1990. One reason the 1989-90 plunge fell short of a crash is that, in September 1989, market valuations were still fairly moderate: The 12-month trailing price/operating-earnings ratio on the S&P 500 was at 14.1.
By March 2000, this same P/E ratio had soared to an inflated 27.8, which helps account for the severity of the market crash that accompanied the comparatively mild recession of 2001. We might think the market was hammered by the terrorist attack of Sept. 11, 2001. But there was already a 12-month decline of more than 20% on the S&P index by March 2001, while the plunge following 9/11 was only half as great.
Even after the 2001 recession ended, however, the economic recovery was sluggish. The market didn’t begin to rebound until the first half of 2003, as gross-domestic-product growth picked up.
The crash accompanying the Great Recession of 2008-09 was the steepest by far, just as the Great Recession was the worst downturn since the Great Depression of the 1930s. But the differences between where we are now and July 2007, the month that marked the beginning of the most recent crash, suggest that a recession, and hence a crash, isn’t about to happen.
LET’S START WITH A REASON to worry. The ultralow interest rates maintained by the Federal Reserve have created a breeding-ground for financial excesses that, when painfully corrected, generally bring recession. But so far, the Fed and the economy have been lucky. If there are excesses in the domestic economy, they aren’t yet significant enough to flash danger.
In the stock market, it’s true that the price/operating-earnings ratio was even lower in July 2007, at 16.3, than the current 20.3. Wharton finance professor Jeremy Siegel points out, however, that the July 2007 reading looked low partly because it reflected bogus earnings in the financial sector that were about to vanish from the calculations. And, Siegel notes, today’s P/E looks high partly because it reflects a lack of earnings in the energy sector, which in turn are due to low energy prices that are providing a boost to the economy.
A more straightforward measure of equity valuation would be the yield on the WisdomTree Dividend Index, which covers the more than 1,400 U.S. companies that pay cash dividends, both now and in 2007.
In July 2007, the yield on the index was 2.9%, at a time when the 30-year Treasury bond yielded 5.1%. Given the plunge in the 30-year bond yield to 2.6% today, you might expect investors to have bid up equity prices so that the yield on the dividend index would be even lower than 2.6%. Instead, it’s at 3.2%, an indication that equities today are valued far more conservatively.
As is well known, the crash in house prices was a prime cause of the 2008-09 recession. While house prices have been rising, they are still well below the peaks of 2007. In April, the most recent month for which data are available, the median price of an existing home was $232,500. In July 2007, the price in today’s dollars came to $263,560.
The price of crude oil is also associated with recession; virtually all recessions are preceded by an oil-price spike. In July 2007, the price was $85 a barrel in today’s dollars, and in a steep uptrend. Today, the price is $49, on the rebound from multiyear lows.
Another indicator of imminent recession is a flat or inverted yield curve. Normally, of course, short-term rates are lower than long-term rates. But, according to a Federal Reserve Bank of New York staff report (“Monetary Cycles, Financial Cycles, and the Business Cycle,” January 2010), when borrowing short costs as much or more than the gains from lending long, this “reduces net interest margin, which in turn makes lending less profitable, leading to a contraction in the supply of credit.”
Right now, the yield curve is relatively normal, with the difference between 10-year and the three-month running a positive 154 basis points, or 1.54 percentage points.
Then there is the danger posed by economic downturns abroad. What if China’s huge economy starts to contract, while Japan and the euro zone continue to stagnate? U.S. exports, already down 1.3% in the first quarter from their fourth-quarter 2014 peak, will certainly take a further hit. But there isn’t a single recession on recent record that can be traced to reversals abroad. As Michael Lewis, president of Free Market, observes, “While a U.S. sneeze can give the rest of the world the proverbial flu, the reverse still doesn’t happen.”
Non-economic shocks tend to be so unusual that it’s hard to draw lessons from past precedent. There is, for example, the shocking and unprecedented chance that Donald Trump will win the White House in November. A Trump victory could spark a market selloff. But whether that becomes a full-blown crash depends on whether the policy initiatives of a President Trump spark recession.
REASONABLE PEOPLE can disagree on that question. But not even the infamous Smoot-Hawley Tariff of 1930 was enough to cause the Great Depression, although it did make it worse. And if a President Trump does push through a cut in taxes, that would mean ballooning deficits over the long term, although it would probably be bullish for stocks in the short term.
If a recession isn’t about to happen, and a crash is therefore unlikely, then what’s the outlook for the stock market? The strongest leg of the bull market is probably over. As economic growth persists, however, the market could still eke out single-digit gains. In 2015, fourth-quarter over fourth-quarter GDP growth ran a tepid 2%, a slowdown from 2014’s 2.5%, largely due to a proportionate slowdown in real consumer spending. Not surprisingly, the 12-month change in the S&P 500 through the second half of 2015 was flat to negative.
But the strong retail-sales report for April signals that a rebound in consumption growth has begun to happen, bolstered by a tight labor market, which is boosting wage and salary income. Also lending support: the steady rise in existing-home sales and the breakout, in April, of sales of new homes. New-home sales spur housing starts, which show up in the GDP accounts as residential investment. But gains in this sector also spur consumer spending. Households invest in rugs, furniture, and appliances when they move into new homes. With these favorable fundamentals, GDP growth in 2016 should accelerate to 2.5%.
That should be constructive for the stock market. Barron’s has found that, looking at the past 20 years, there have been 35 calendar quarters in which growth in real GDP ran higher than the same quarter a year ago. In all but a handful of those cases, the 12-month change in the S&P 500 was positive.
Among life’s certainties are death, taxes, and market crashes. Death, of course, can be postponed by modern medicine, taxes can be deferred, and market crashes can be delayed by an expanding economy. They all catch up with us sooner or later, but in the case of market crashes, investors can mitigate the harm they bring.
If stock valuations looked way too exuberant; if the inflation-adjusted house price were far above its previous peak; if the yield curve were flat or inverted; and if the price of oil were surging to triple-digit peaks—then investors might want to resort to defensive measures, like selling everything and going short. But odds right now are that the bull market has not finished its run.