Opinion: The elements for a big stock market drop are aligning. Here’s why investors shouldn’t panic
When is the next stock market crash taking place?
It's a question I get asked often since I wrote «A History of the United States in Five Crashes – Stock Market Meldowns That Defined a Nation.» Until now, I've always been able to counsel that stock market crashes are comfortingly rare events that only occur when elements align, and that a crash is unlikely in the near future. Is this still the case? Let's discuss.
It's always helpful to examine the elements that foster a crash. The first is a frothy stock market.
It is no accident that the first modern stock market crash, the Panic of 1907, occurred after the biggest two-year rally in the history of the Dow Jones Industrial Average. The benchmark gained 95.9% from 1905 to the end of 1906. The crash in 1929 occurred after the second-largest two-year rally ever, up 90.1% from 1927 to 1928. More recently, the S&P 500 was up 43.6% for the year on Aug. 25, 1987, and the largest crash in history occurred 38 trading days later wiping away all those gains and more.
The second element for a potential crash is rising interest rates. It was the Federal Reserve that pushed short term interest rates from 1% in May 2004 to 5.25% in September 2006 and unsettled the shadow economy — while making stocks less attractive as you could make a decent return with no risk by buying T-bills.
The third element is some newfangled financial contraption that injects leverage into the financial system at the worst possible time. In 1987, it was the ill-named portfolio insurance — which was really just a scheme to sell stocks or stock index futures in increasing numbers as the market fell. In 2008, it was mortgage-backed securities and their metastatic offspring such as collateralized debt
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