Analysts have been warning about a potential stock market bubble since mid-2017 — and many now believe that stock market is getting quite close to exactly that. Though there are rarely any clear indications of a financial bubble, there signs are getting pretty hard to ignore.
While analysts still debate what caused other stock market crashes, they are generally believed to occur for a few reasons. Stock market crashes often start with a moment of panic, which cascades down to widespread unrest. Fluctuations within the market — or true weaknesses being revealed in the market — cause a cyclical effect. Investors panic and pull out of the market, which leads to the market going down, which in turn leads to more panic.
But though stock market crashes revolve around investor panic, they are not solely the work of panic. Generally, the stock market crashes after a period of artificial inflation. As of late, it was the Dot Com boom and bust followed by the housing market bubble of the late 2000s. In both situations, the markets experienced rapid, extreme growth before their collapse.
Let’s see if we can find any parallels in the market today.
Signs of an Impending Crash
It may seem counterintuitive, but a stock market crash can easily come at a time when things appear to be going very well. Currently, the stock market crash appears to be precipitated by two major things:
Overvaluation of the Stock Market
As the economy has improved, investors may be throwing their money into the stock market too fast, leading to inflated stocks that are well beyond their true value. This could trigger a rapid devaluation.
A Drying Up of Liquidity
As the government and lenders become concerned about a potential stock market crash, they will pull back on lending. This includes actions by the federal reserve. As liquidity dries up, investors may panic and begin to pull out of the market all at once. This, combined with natural overvaluation, could lead to a situation that spirals into a full-fledged crash.
On the other hand, the market is currently experiencing very low rates of volatility. Some believe that this low volatility will lead to a market correction rather than a market crash. But what is the difference between the two?
The Difference Between a Crash and a Correction
Defining a crash or a correction can be difficult, but critical for evaluating the real state of the markets. Moreover, there’s no solid line between the two. Some would define a crash as 20% loss of value, while others might define a crash as up to 40% loss of value. A correction is often considered to be a loss of 10% of value.
Philosophically, a correction is simply the market forces at work to re-value over-valued stocks. This is a natural phenomenon. A crash generally happens after a market correction. When investors react to a market correction by continuing to pull out of the market — even beyond the actual value of their stocks — it becomes a crash.
Dissenting Opinions Among Analysts
Of course, not everyone believes that we are in for a market crash any time soon…or even a market correction. Major voices such as Warren Buffet have questioned whether stocks really are overvalued. Instead, some believe that stocks are now at the right price because interest rates are so low. As the economy improves, the stock market values may truly be increasing at substantial rates of growth.
Low volatility within a market isn’t necessarily a sign that a market crash or correction may not be on the way, but it may indicate that a crash would be more difficult to trigger. With low volatility, investors are less likely to panic as the market falls, and are less likely to draw out.
On the other hand, some analysts suspect that investors may have become too used to the low volatility and fast pace of the market, and hence may actually become more alarmed should the market self-correct. With relatively smooth sailing for a significant amount of time — and very few negative signs — investors could take a market downturn as a dangerous sign.
Is the market headed towards a crash? Many analysts say yes. If you believe that the market is overvalued, it’s only a short jump to believe that a correction may be on the way. Where analysts largely differ is whether the psychological impact of such a correction would be enough to potentially lead to a crash.
What is certain is investors who are able to capitalize upon such a crash or correction will be quite successful.
Regards,
Ethan Warrick
Editor
Wealth Authority
