All in all, it was another great year for the stock market. Until Wednesday, December 1st, benchmark S&P 500 (^ GSPC -0.84% ) has increased by 20% since the beginning of the year. When you consider that the widely used index has had an average total return of 11% including dividends over the past 40 years, this is solid performance.
However, last week has been a head-to-head race for the stock market and volatility has changed a lot. As investors, we may not like to think of stock market crashes and double-digit percentage corrections, but they are the price of entry for participating in one of the world’s greatest wealth creators.
At the moment, there is no shortage of catalysts that could overturn the S&P 500 for its first crash or its first correction since the pandemic began. Here are nine reasons the stock market could crash in the next three months.
1. Omicron / variant spread
Let’s start with the obvious: the coronavirus and its growing number of variants.
That year, the S&P 500 posted more than five dozen record-high closing prices. It was expected that rising vaccination rates in the US and worldwide would allow business to return to normal. But with each new variant of COVID-19, there is the potential for additional bans, restrictions, supply chain concerns, and a possible decline in consumer or business spending.
The emergence of the Delta variant in May led to a short-term market slide that was put into the rearview mirror relatively quickly. The same could be true of the Omicron variant, but we just don’t know enough about it right now for Wall Street and investors to be confident buyers of stocks.
2. Historically high inflation
In a growing economy, some level of inflation (ie rising prices for goods and services) is expected. However, the 6.2% rise in the consumer price index for all urban consumers in October marked a 31-year high.
The problem with inflation is that it can weaken the purchasing power of consumers and businesses. Even if workers’ wages rise, much of their purchasing power could be drained from them by rising rents / home costs, significantly higher energy prices and even above-average food inflation.
If the next few US Bureau of Labor Statistics inflation reports are at or above 6% in the past 12 months, the likelihood of a temporary price spike will go away. Wall Street won’t like that.
3. Energy price digestion
Crude oil could also be doomed on Wall Street in the next three months.
In my opinion, crude oil is the most capricious commodity. When the price spikes too high, consumers and businesses either buy less fuel or, if businesses can, pass higher fuel costs on to customers. On the other hand, if crude oil prices are afraid of some other variation, it can hurt job creation in the energy sector and even lower general confidence in the US or global economy.
In other words, the oil market needs to offer some semblance of stability over the next three months. If the price per barrel jumps above USD 80 again, fears of inflation could dominate. If it falls below $ 50, sector-wide investments could be cut.
4. Fed speaks
The Federal Reserve’s tone and actions could also crash the stock market over the next three months.
For much of the past decade, it was the country’s central bank extremely accommodating. This means that interest rates have been held at or near historic lows, which has allowed growth stocks to borrow cheaply for hiring, acquisitions, and innovation. In addition, the Fed has been buying long-term government bonds and mortgage-backed securities fairly aggressively in an effort to fuel lending and confidence in the real estate market.
But in the face of soaring inflation, the Fed will have no choice but to eventually raise rates and slow down its bond-buying program. To put things mildly, investors have been pampered with historically low lending rates for a long time. Any talk of a faster-than-expected rate hike could quickly bring the S&P 500 down.
5. A dead end on the debt ceiling
Keeping politics out of your portfolio is generally a smart move. But every now and then politics must not be swept under the carpet.
We are currently less than two weeks from the December 15 deadline for reaching the national debt limit. If we hit the debt ceiling without an agreement in Congress, the Treasury Department would not be able to borrow. This means federal employees may not get paid if inflation rises and the US economy is still on its feet after a nasty (but brief) recession. It can even mean the US is defaulting on some of its debts, which could adversely affect its creditworthiness.
To be clear, this isn’t the first rodeo for lawmakers when it comes to a debt ceiling stalemate. But the longer Congress waits to resolve things, the more likely the debt ceiling could weigh on stocks.
6. Margin Debt
In general, margin debt – the amount of money borrowed from a broker with interest to buy or sell short securities – is bad news. While margin can multiply an investor’s profits, it can also quickly enlarge losses.
While it is perfectly normal for nominal margin outstanding debt to grow over time, the rate at which it is rising in 2021 is very alarming. There was almost $ 936 billion in margin debt outstanding as of October, according to the Financial Industry Regulatory Authority. That has more than doubled since the middle of the last decade.
More importantly, margin debt increased more than 70% earlier this year compared to the same period last year. According to analytics firm Yardeni Research, there have only been three cases since 1995 where margin debt has increased over 60% in a year. It happened just before the dot-com bubble burst, months before the financial crisis, and in 2021. That doesn’t bode well for the stock market.
7. The settlement of meme stock trading
Twice a year the Federal Reserve publishes its Financial Stability Report, which examines the resilience of the US financial system and outlines some of the larger short- and longer-term risks that are worth monitoring. In the most recent report, the country’s central bank looked at the possibility of young investors turning their money into meme stocks such as AMC entertainment and GameStop could increase volatility and disrupt the market.
The report notes that the younger investors involved in these trades “tend to have more leveraged household balance sheets”. Losses in the market would make these people more vulnerable to paying their debts. In addition, the risk is further increased with these individual, regularly buying options.
The Fed also notes that social media interactions, including broadcasting biased or unsubstantiated allegations on message boards, could lead to increased volatility and a âpotentially destabilizing outcomeâ.
The valuation alone is often not enough to overturn the stock market. But when market valuations hit historically high levels, that’s a whole different story.
On December 1, the S&P 500’s Shiller price-to-earnings (P / E) ratio was 38, and it had recently hit 40 for the second time in 151 years. The Shiller P / E ratio takes into account the inflation-adjusted earnings of the last 10 years. For comparison, the average Shiller P / E for the 1870 S&P 500 is 16.89.
However, it’s not worrying how far above its historical average Shiller P / E ratio is. After the previous four instances where the Shiller P / E was over 30, the S&P 500 eventually lost at least 20% of its value. When the ratings get stretched, as is the case now, history has shown that crashes become commonplace.
9. Investors stick with the story
A ninth and final reason the stock market could crash in the next three months is history. Especially if investors think history repeats itself, the S&P 500 could get into trouble.
There have been nine bear markets since 1960. After each of the previous bear market lows, with the exception of the coronavirus crash, we saw either one or two declines of at least 10% within 36 months. In other words, recovering from a bear market low is a process that often hits speed bumps.
But since the low on March 23, 2020, it’s been an almost straight jump up for the S&P 500. If Wall Street and investors were betting on history repeats itself, they could loosen their portfolios in anticipation of a double-digit percentage pullback or crash.
This article represents the opinion of the author who may disagree with the “official” referral position of a premium advisory service from the Motley Fool. We are colorful! Questioning an investment thesis – including one of our own – helps us all think critically about investing and make decisions that will help us get smarter, happier, and richer.