What are the odds of a 1987-style stock market crash before the year is out?
Higher than you may think...
First, let's look at why U.S. markets have been so strong. Then I'll explain why I believe the party could be about to end violently.
So far this year, U.S. stocks have handily outpaced the MSCI World (ex-U.S.) Index. And the major U.S. indexes -- the Dow Industrials, the Dow Transports and the S&P 500 -- have been at or close to multiyear highs... even in the face of eurozone member Cyprus' near meltdown.
There have been four important factors supporting stocks:
- A surprisingly strong housing recovery
- Evidence of accelerating consumer spending
- Increasing pressure from retail investors to own more stocks
- Confirmation the Fed will stay on "hold" with its monetary easing.
But the fourth reason for stocks' recent highs is the strongest: confidence that the Fed will stay on "hold." In other words, that it will keep interest rates ultra low... and keep the printing presses whirring... for years to come. That's because much of the cheap credit is flowing into stocks.
The problem is that interest rates can't stay ultra low forever. Nor can the Fed keep its foot on the stimulus pedal indefinitely.
This is critically important. Because when it comes to stock market expectations, investors pay too much attention to the broad economy and not enough attention to credit conditions.
Stocks can tread water even when the economy is weak, if credit conditions are loose enough. And they can fall even when the economy is strong, if credit conditions are transitioning from loose to tight.
But they can really shoot up, if the economy is growing and the Fed is easing, as this chart courtesy of Gluskin Sheff shows. In fact, the average annual gain for the S&P 500 when the economy has been growing (no matter how anemic that growth is) and the Fed has been easing has been 11%.
View Larger Chart
The problem is the Fed must tighten credit conditions eventually. And the stronger the economy looks, the sooner it will have to do so.
But bullish stock market investors do not want to see the Fed tightening. And any sign that the Fed is about to turn off the money spigots could trigger a 1987-style crash.
Don't forget that 1987 was great for stocks -- up until the weekend of the October crash. Euphoria had broken out, with excellent credit conditions fueling the party.
Then a giant needle scratched across the record... with no forewarning other than general observations as to how dangerously overextended markets had become.
A stock market crash is a bit like an avalanche in wait. With tons of loose rock in precarious position, it becomes increasingly possible for a random pebble or loud noise to kick off the disaster.
The irony is that accelerating U.S. domestic strength could encourage investors to pile harder into the market and trigger the coming avalanche (when mass realization that interest rates will be forced higher hits).
For your own portfolio, there are at least three ways to prepare: mentally, financially and strategically.
Mentally -- Steel yourself. Be aware that the higher euphoria rises, the higher the odds of an unexpected crash event (or violent downside dislocation), which could come with little warning.
Financially -- Maintain a war chest of cash reserves. Not only does cash provide stability in times of turmoil, its value increases dramatically in the aftermath of a crash (via fire sales on high-quality assets).
Strategically -- Consider adding a mix of shorts in overbought and overhyped companies with weak fundamentals to your portfolio alongside longs.
Carpe Divitiae,
Justice
Editor's note: In the portfolio of my new service, Strategic Wealth Report, I will be preparing for a potential crash through a mix of bullish and bearish positions. Offset against our long-side moneymaking opportunities, I will seek out safe ways of taking bearish positions in select areas of the market. These positions could return hundreds -- even thousands -- of percent in the event of a full-on crash. Stay tuned for details on how to subscribe...
