Five factors that signal the threat of a stock market crash

by Benjamin Feingold & Egmond Haidt


24th July, 2017

Risk elements are increasing

Is the current stock market rally grinding to a halt? From all the major indices, the DAX has had to take considerable losses due to the current strength of the Euro. However, a similar fortune could await other stock markets – the risks cannot be overseen.  Analysts at the Bank of America recently wrote the following “In three of four months we will experience the most dangerous period for the equity markets”. The following five arguments are according to them and other market analysts valid signals for a coming correction.

 

Trump seems to have lost the plot:

Many investors are still hoping that US president Trump will bring the multi-million tax reform through Congress and thus bring more swing into the current dwindling economy. Since Trump has failed dismally to realize almost all of his plans up to now, many investors are starting to wonder whether Trump will succeed in bringing about this tax reform. Should this not be the case, then future perspectives for the economy would darken further – bad news for the stock market.

Current valuations are extremely high:

After years of money printing by the US Fed, the EZB and the Japanese Central bank, the S&P500 is currently valued with a price-earnings ratio of 17.7, an extremely high level rarely seen in the past. The long-term average is around 11 -12 which corresponded to long-term company growth.  The problem however, is that not only US equities are expensive, but also those of many other countries. Thus the price-earnings ratio for industrial countries figure at 16.5, which is close to that of the S&P500.

The China bubble risk:

Many experts worry about China.  Although the economy grew in the second quarter 6.9 percent above the same period last year and slightly better than expected, this growth came about on the back of enormous company debt with property valuations rising to extremes.  If a correction takes place then it would put critical pressure the economy.

Investors have become extremely reckless:

The VIX, which reflects the volatility of the S&P500 is now under 10 points which is close the lowest valuation since the end of 1993. This is a sign that investors are not even pricing in increasing volatility on the US stock market.  Investors in such an environment are hardly nervous and don’t reckon with heavy losses. Such an attitude can easily spark off considerably heavier market losses. One positive aspect of the current low volatility lies in the fact that the prices of put options are relatively cheap and act as an ideal vehicle to hedge open long stock positions. Careful investors can currently protect themselves from future market turbulence at a relatively low cost.

Yellen could practice shock therapy on the market:

Yellen and her colleagues have repeatedly indicated why they wish to raise interest rates: because of the very high asset valuation, in particular stocks. Nevertheless the S&P500 jumps from one record to the next because investors are betting on the fact that due to the weak economy, Yellen will give in and will not raise interest rates to levels previously targeted. However Yellen could surprise everyone and make it quite clear that she means what she says and raise interest rates by 50 basis points at the next meeting on September 20th. This would send out a very strong signal to the stock market and could mark a major trend reversal. At the moment it seems that nothing can spoil the party on the US and global stock markets. This could be the reason why many investors are looking back to the years 1999 and 2007. While nobody can predict if and when a crash could occur, investors should not throw caution to the wind.