For the first time in over 10 months, the stock market is showing signs of fatigue.
In a roughly one-month stretch from early September to early October, the benchmark S&P 500 (SNPINDEX:^GSPC) shed about 5% of its value. It’s a drop in the bucket compared to the index’s gains since the March 2020 bear-market bottom, but it’s a potentially stern reminder that a stock market crash or double-digit correction could be around the corner.
Fundamentally speaking, a crash or correction appears likely
To be clear, it’s impossible to predict with any long-term accuracy when a crash will occur, how long it’ll last, or how steep the decline will be. But given the frequency of moves lower in the market throughout history, warning flags should be raised.
Fundamentally speaking, there is a trio of worrying metrics. First, margin debt has soared in 2021. Margin debt describes the amount of money borrowed with interest to purchase or short-sell securities. According to data from market analytics company Yardeni Research, there have been only three instances since the beginning of 1995 where margin debt jumped 60% or more in a single year. The previous two instances occurred right before the dot-com bubble burst and months before the financial crisis that caused the Great Recession.
Second, inflation is picking up in a big way. Crude oil settled at its highest close in seven years this past week, while the core Consumer Price Index, which excludes food and energy, surged by its highest rate in about three decades. While some level of inflation is positive for a growing economy, high rates of inflation can stifle consumer spending and bring economic growth to a halt.
And third, S&P 500 valuations are stretched. As of Oct. 12, the S&P 500’s Shiller price-to-earnings (P/E) ratio stood at 37.6. The Shiller P/E takes into account inflation-adjusted earnings over the past 10 years. What’s concerning from a valuation perspective is that in the previous four instances where the S&P 500 has surpassed a Shiller P/E of 30, it’s eventually gone on to lose at least 20% of its value.
History says we could be headed for trouble, too. Following each of the previous eight bear-market bottoms, dating back to 1960, the S&P 500 has undergone either one or two declines of at least 10% within three years. In other words, bouncing back from a 20% or greater drop in the broader market is a process that takes time. The fact that the market has gone almost straight up doesn’t jibe with history.
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