In today’s issue:

  • Market crashes are unexpected, sort of
  • They tend to have different specific causes
  • Yet they also have things in common

No, I’m not predicting an imminent stock market crash. I do, however, observe that the conditions are ripe for one.

Let’s look at a handful of major crashes in decades past to understand why.

First stop, 2008. We know how the collapse of Lehman Brothers triggered not only a huge decline in the stock market but a general global financial crisis.

But that crash didn’t just happen out of the blue. Stocks had been declining for about a year prior. Talk on the trading floors where I worked at the time –Deutsche Bank – was about how everyone knew the US housing and mortgage party was over. The debate had moved on to whether the hangover would pull the US economy into recession.

But stock market valuations remained historically high. The trailing price-to-earnings (P/E) ratio of the S&P 500 index was 23 when the market peaked in 2007. As earnings began to decline, the P/E rose, reaching nearly 30 by the time of Lehman’s collapse.

That collapse might have been the trigger for the crash, but when the smoke cleared and the market had lost over half its value, few were of the opinion that the prior, historically elevated market valuation was justified.

Now let’s take a look at the tech-led crash of 2000. Ever since the Federal Reserve organised a bailout for Long-Term Capital Management in 1998, including several emergency interest rate cuts, high-flying tech stocks had been leading the overall market to record highs.

Valuations became even more extreme than in 2008. At the start of 2000, the trailing P/E for the S&P 500 was over 30. From a peak of about 2,800 in 1999, the market would go on to lose about half its value by 2002.

The high-flying tech stocks that had led the rally lost far more. Many went to zero.

Some of those companies had never turned a profit. Of those, some had never even generated revenues, being still at the development stage of some miraculous breakthrough tech or e-commerce monopoly fantasy.

And what of the trigger? This is harder to pinpoint. Some say that tech became so delusionally overvalued that the bubble simply popped from overstretched optimism.

A few claim that the Time Warner-AOL merger was an important signpost of a successful tech firm cashing out its chips at an absurdly high valuation. If one firm could do it, why not others? And so, the selling came.

As per 2008 above, after the fact, few were left wondering why the crash had happened. Clearly, valuations had become absurd and some sort of reckoning was inevitable.

Let’s rewind to the 1980s. The stock market crash of October 1987 – likely sparked by fears of aggressive Fed rate hikes – came about a year after former Fed Chairman Alan Greenspan warned of “irrational exuberance” driving valuations to unsustainable highs. When the market plunged 20% in a single day, that exuberance vanished almost overnight.

The precipitous 1987 crash might have been an echo of the early 1980s. At that time, much of world had been enduring years of “stagflation”. In 1979, when President Carter appointed Paul Volcker as Fed chairman, it was with a clear mandate: tame inflation – no matter the cost. Even if it meant triggering a recession, Volcker was expected to do whatever it took to bring prices under control.

Sure enough, Volcker raised rates sharply, the dollar strengthened, inflation came down and the stock market tanked. The S&P 500 fell from about 500 in 1980 to 350 in 1982.

At the start of the stagflationary 1970s the S&P 500 was trading at a P/E in the high teens. In 1982, when Volker brought rates back down and the stock market began to recover, it was below 10.

Now, while all four of the above crashes are different in their macroeconomic contexts and specific causes, they all share a similar characteristic: they begin from historically elevated market valuations. Once the crashes have run their course, valuations are either outright cheap or at least have settled close to their long-term averages.

But there is one other thing to note: as with so many things in life, hindsight is 20:20. Observers look back at the above crashes and, without much effort or mental gymnastics, conclude that some sort of crash was probably inevitable.

“No one saw it coming” was a common refrain following the global financial crisis of 2008-9. But that wasn’t being said of the stock market, which had merely returned to a valuation close to the long-term historical average.

Rather, it was about Lehman’s failure and how that cascaded through the system, bringing down multiple major financial institutions and triggering government and central bank bailouts all around.

The fact is, when markets crash the narrative rapidly shifts from “no one saw it coming” to “of course the market was overvalued” and “it was only a matter of time” and such.

Which begs the question: what about today? Were the market to crash tomorrow, would investors be scratching their heads and wondering why? Or would they be able to make quick sense of it?

Stay tuned, because tomorrow I’m going to offer my current thoughts on precisely that.

Until next time,

John Butler
Investment Director, Fortune & Freedom