Is the stock market going to crash?
Given everything that's currently going on in the world and occurring politically here in our own country, the average person faces many dangers with respect to money tied up in the stock market. In fact, many investors don't even realize that they're about to lose everything!
Take a deep breath and relax—I'm kidding. I would never open an article with such a frightening and misleading message. However, many others writers do, as we have discussed in previous articles and blog posts: specifically, those that warn about financial gurus who use the “fear factor” to persuade their audience to move money into their products and advisory business.
There's a good verse in the New Testament—in Romans chapter 13 verse 3, that talks about how if we just follow the law, there is no need to worry about the government coming after or arresting us. Investing mimics this notion. In many previous articles, I've talked about diversification and the need to follow God's Biblical principles when handling His money, and if we follow these principles, there is no need to worry about a potential stock market crash. That being said, for the purpose of this article, we will in fact discuss this very same topic today.
As we begin to ponder a stock market crash here in 2021, so many people enjoy asserting that they know exactly what will happen. On the flip side, I can say with complete confidence that I do not know what lies ahead. This calls to mind a Bible verse I've mentioned before that is worth mentioning again. Penned by one of the wealthiest men that's ever walked the face of the planet—and I believe was inspired by God Almighty Himself —
Ecclesiastes 11:2 says, "Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land."
As we consider the stock market in terms of where we've been and where we might be going, it's important to understand that nobody knows what the future holds except for the Lord. Nobody can accurately predict when the stock market will rise or fall, just like nobody knows when the Lord Himself will come back.
As we examine the current state of the U.S. stock market and take a step back to consider the current valuation, conditions are less than favorable for avoiding a crash in the near future. Before we forge ahead and discuss the current valuation, let’s talk about what this means. What I’m referring to is the price-to-earnings ratio: meaning the measure of a company's stock price in relation to its earnings.
If we buy, for example, Coca-Cola stock, and its price-to-earnings ratio is 25, this means the stock is currently trading at 25 times its earnings. Real estate can be valued in this way as well based on price per square foot, which is one way to value a home. Therefore, as we look at stocks, let’s zero in on this concept. The valuation is the price-to-earnings ratio: low P/Es infer that the stock represents a good value at a cheaper price point than those with a high P/E ratio.
One thing that's important to understand about this ratio is that companies with historically lower P/Es are not expected to grow as quickly as those with higher ratios. This summons a whole other discussion, but in general, history tells us that in the past, companies boasting what we call “value stocks” with lower P/Es performed better over an extended period of time than their counterparts. However, in the last decade or so, companies with higher price-to-earnings ratios—or “growth” stocks—have outperformed value stocks overall.
Let's examine the historical range of the S&P 500's P/E ratio. These 500 companies in the U.S. (which most people know by name) usually trade between 13 to 15 times their earnings, which is their typical price.
So today, as we consider the current price-to-earnings ratio of the S&P 500, we see that it's roughly 35 toward the end of September 2021: meaning S&P 500 stocks are currently trading at more than double their historical price. Now, one could look at this and say, "Oh, that's wonderful! This means investors are expecting S&P 500 company earnings to grow at double their normal and historical growth rate." However, this is in fact not typically the case. Rather, when we observe fluctuations in the price-to-earnings ratio, “herd investing” and “herd movement,” if you will, are usually responsible for this movement.
Allow me to explain what I mean when I say herd investing. Investors and people at large who put their money into the stock market will begin to get excited and emotional when they see stock prices rise, proclaiming, "Well, I'm going to sell my money in bonds. Stocks rose 12% last year, and my bonds are only paying me 3% or less, and so I’ll go ahead and shift some of my money from bonds into stocks. Or perhaps I'll change my stock contribution rate from 50% to 60% since the stock market rose 10% or more each year for the past three years." With this in mind, investors tend to become more and more comfortable and seek to take further advantage of these returns upon seeing a rise in the stock market.
They don't want to miss out, and in turn, adopt a “herd” mentality as more and more people move their money into stocks.
We see this behavior all the time on National Geographic shows when, for example, bison, antelopes, or buffalo move in herds on plains or prairies. Perhaps one spots a lion, watering hole, or pasture with copious grass for grazing. When this happens, one or two animals will begin to move accordingly. Soon enough, three, then five, then 10 and 12 follow, and before you know it, over 100 animals are all scurrying in the same direction: and it all just started with a few in the herd!
The key takeaway here is that a price-to-earnings ratio of 35 has historically told us that people are now more comfortable investing in stocks than they were in the past, when many typically shunned the idea of paying more than 13 to 15 times the price of a stock for S&P 500 companies. However, during isolated time periods—for example, following the dot-com bubble at the end of the 90s—people have been known pay more than 40 times the earnings for S&P 500 corporations. Investors were extremely comfortable and confident in stocks at the end of this bull market, which started in roughly 1982 and lasted for 18 years, increasing their willingness to pay upwards of 40 times a company's earnings.
The herd believes it is impossible for stocks to go down and will thus pump as much money as they can into stocks because they supposedly only do one thing: go up. And so, here we are in Year 12 of our current bull market that began in February 2009, enjoying a price-to-earnings ratio of 35—more than double the historical comfort threshold with respect to paying for S&P 500 stocks.
This does not give me a whole lot of confidence when it comes to future earnings. During the 2010s, many experts—including those at Morningstar Research and Vanguard founder John Bogle—believed that in the following decade, the average rate of return for U.S. stocks would hover somewhere around 3-4% (nominally, before adjusting for inflation). Aside from just purely looking at valuation using the price-to-earnings ratio, another consideration is observing S&P 500 Index performance over the past 10 years. This reflects an average of about 17% per year over the last decade alone, which is higher than the historical 40-year average of about 10%.
Going back even farther, if you consider the S&P 500 from the 1920s all the way through 2019, the average maintains that 10% mark. As such, anyone—even an elementary school student—can look at the past 10 years and see that approximately 17% does not fit, and we're 6% above average per year. Now certainly, it’s important to keep in mind that the first decade of the 21st century was pretty dreadful, and, in turn, one could argue that we were due to catch up a little bit. Yet, as we examine stocks since the whopping 35% market plunge of March 2020, the S&P 500 in fact went on to rebound dramatically in the 18 months thereafter.
Whether we are investors or educated people curious about investing and/or consider the price-to-earnings ratio or historical performance, we will ultimately uncover the same data and can draw the same conclusions: that stocks are probably primed for some sort of correction. We don't know the exact date. We don't know the exact numbers. We don't know the exact amount of time it will last. Yet, paradoxically, stocks certainly had a lot more promise back in 2009 when investors lacked confidence both in the economy and stock market itself than they do right now: a time that has seen investors drive stock prices up around 17% annually over the past decade.
So, let’s consider the original question once again: Is the stock market going to crash? The answer, my friends, is yes. I don't know when, and I don't know by how much, but I do know that a bear market is considered anything more than a 20% index drop. I also think it's reasonable for us as investors to expect a 30-to-50% drop in S&P 500 prices at some point in the coming years. Unfortunately, we simply don't know when that will happen. One thing we do know about drops is that they occur a whole lot faster than rises do.
If you would like to seek out my advice about your portfolio and learn how to best prepare for a future stock market crash, feel free to click on this link and set up what we refer to as a “retirement ready” success call. There's no cost or obligation, and I would be happy to review where you are now, where you want to be, and share some tips that have worked particularly well for some of my clients.