Is the stock market going to crash?

will the stock market crash?

I read an article yesterday in a publication that was forwarded to me showing a variety of indicators suggesting the stock market is going to have a major drop in the near future.  This particular publication is constantly putting out articles like this and I provided the following reply.

I’m not a big fan of this kind of thing for several reasons:

 

  1. Lots of groups – like FIR – make their money off constant gloom and doom stories, take a look back over the articles you’ve sent from them for the last few years and it’s a steady stream of warnings about how things are going to collapse (remember our conversation last summer about them saying the big correction was coming in September, we saw that drop in August, which was a great buying opportunity and then recovered pretty quickly and in spite of some little ups and downs has remained relatively flat).  This makes sense because fear sells, but it’s not an accurate world view as measured by what’s really been going on
  2. It makes the fatal mistake of believing the past equals the future but as we know history is not destiny a lot of things are different today from how they were decades ago so the real question isn’t what happened in the past but what are the drivers that will create change right?  If the drivers have changed then we can’t expect the same outcome.  This is arguably why 2008-2009 wasn’t as bad as 1929, because we had a banking system in place with an ability to jump in and prevent things from falling as far as they did back then

 

None of this is to say they are mistaken, they might not be but let’s look at the fundamental drivers and be rational about it.  Here’s where I’m a big fan of Buffett who has frankly far outperformed all of these guys for decades so based on results he might be worth listening to.  Or Ray Dalio who fits the same mould.  Ed Bogle is a pretty good one as well.

 

Let’s start with the basics.  What causes the market to go up?  Money going into it.  Literally, no rise can happen within the market without more money going into it so for it to rise the money has to come from somewhere.  Over the last few years that money has primarily come from quantitative easing, which has now stopped (Dalio believes they’ll have no choice but to initiate QE4 at some time in the not too distant future so we’ll see if that happens).  In a sense they poured trillions of dollars into the system by swapping government bonds for bank reserves on bank balance sheets and this had the effect of driving up the market a lot more than it would have without those initiatives.

 

Now that this has stopped the money can only come from a few places:

 

  1. Government deficit spending – this is the only way the base money supply grows and might happen to a small extent but doesn’t look probable at levels that would make a big difference measured against the scale of the economy
  2. Foreign investment – the question is “from where”?  China?  Not likely, not with the state of the economy over there.  Europe?  Same boat.  Really any amount of foreign investment large enough to substantially move the needle seems pretty slim
  3. Private debt – the credit markets could expand substantially, which is what happened leading up to 2008 but what would drive that?  Normally, you need rising asset prices (not very likely), falling interest rates (virtually impossible), easing lending rules (pretty unlikely), rising household income (not likely to be enough)
  4. Share buy backs – this could happen to some extent but probably not enough to move the meter substantially

 

Bottom line the forecast of pretty much everyone significant that I know of is the market isn’t going to grow much in the next 10 years.  Whether you want to take that timeline or shrink it down a bunch to say 3-5 years I don’t see any drivers baring another round of QE and a significant one that would push the market as a whole up substantially.

 

Let’s look at the opposite is the market likely to drop substantially?  Again the inverse is true here what causes the market to drop?  When money gets pulled out of the market.  Typically, when there’s a rapid collapse it comes from two things:

 

  1. Debt bubbles bursting because people can’t afford to service the debt they’ve taken on – this is what has been happening in China where people are buying on margin rather than with cash and is also what happened with the housing market in 2008.  The problem is there isn’t a major debt bubble in the US markets right now, I just read a report that household net worth is the highest it has been since the 1980s.  If interest rates rose substantially that could create problems but is that very likely?  You’d need to see substantial increases in inflation for this to happen and even then the Fed will be monitoring it closely.  I’d imagine as the price of oil recovers, which it will probably do over the next year or two you’ll see an upward tick in inflation and there’s a reasonable chance of small interest rate hikes but not ones substantial enough to force a lot of defaults especially since most of the debt is amortized long term
  2. Fear – this is what happened in August and again at the start of 2016 people panicked and sold based on what was happening in other parts of the world, this could well happen but if it’s not backed by real fundamentals represents a buying opportunity because it will turn around as it did in both of those cases.  To quote Ben Graham in the short term the market is a popularity measuring machine in the long run it is a weight measuring machine (meaning it measures profits).  I think it’s stupid to speculate on what public sentiment will or will not be it could go in any number of directions but it’s impossible to say in advance.

 

Those are rapid drops but there could also be a gradual decline, which might come from a couple major sources:

 

  1. Decreasing corporate earnings – earnings definitely slowed at the start of the year due to weakening demand in markets such as China.  You could have definite ebs and flows here, at the moment general market P/E ratios are high but not extremely high, they are still within the bounds of reason so I’m not worried about a major correction but also wouldn’t advise buying general indexes.  Realistically, corporate earnings aren’t likely to drop much but they might not continue to rise as much
  2. Slowly rising interest rates – essentially, this means less margin and a more from money away from equities and indo bonds.  This would be a very slow process and wouldn’t likely push the market down so much as keep it flat
  3. People selling for other reasons – for example you’ll sell stocks to buy a home.  This is the biggest concern because as Robert Kiyosaki pointed out 2016 is the first year baby boomers are starting to retire and will begin selling their portfolios to pay for their living and this is going to continue for 15 years.  “Demographics are destiny”.  This will be fairly gradual but will also be substantial and I don’t see enough new money coming in to counteract it

 

If we look at those drivers what does this all tell us?

 

We probably aren’t looking at a massive sustained crash, it’s possible but pretty unlikely in the near future, a lot of things would need to go wrong at the same time.  On the other hand there’s VERY SMALL chance of any major market gains so most of the returns are likely to be in the form of dividends.

 

This brings us full circle to the Buffett insights.  Buffett says don’t pay attention to all that macro economic stuff.  Instead look at a company that’s producing solid earnings for a decent price and is going to continue producing solid earnings.  Buy that company knowing so long as it continues to produce more and more cash you’re going to be good no matter whether the market goes up or down or sideways because ultimately company cash becomes shareholder cash.

 

In this market I think if you want decent returns you need to focus on individual companies at specific times rather than the market as a whole because the market as a whole is pretty likely to look a lot like Japan for the last 2 decades.

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