There are a lot of things we don't know about stock market crashes. For instance, we'll never be able to pinpoint when they'll begin, how long they'll last, how steep the decline will be, or -- in many cases -- what'll be the catalyst that sends the benchmark S&P 500 (SNPINDEX:^GSPC), iconic Dow Jones Industrial Average (DJINDICES:^DJI), and tech-heavy Nasdaq Composite (NASDAQINDEX:^IXIC) lower.
And yet there's one constant: They happen with greater frequency than you might realize.
Though investors might prefer to cover their eyes and ears when the words "stock market crash" are uttered, the perceived likelihood of a crash occurring relatively soon is growing. All five of the following things would suggest that big drops in the S&P 500, Dow Jones, and Nasdaq Composite are imminent.
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1. Historically high valuations are bad news
To begin with, the widely followed S&P 500 is pricey...really pricey. As of the close on June 7, 2021, the Shiller price-to-earnings (P/E) ratio for the S&P 500 hit 37.5. The Shiller P/E, also known as the cyclically adjusted P/E (CAPE) ratio, is based on inflation-adjusted earnings from the previous 10 years. This reading of 37.5 is well over double the average Shiller P/E ratio of 16.8, which dates back 151 years.
However, this isn't the scariest aspect of the current Shiller P/E ratio. Even more worrisome is what's happened in the previous four instances where the S&P 500 Shiller P/E topped and sustained a reading of 30 -- namely, losses ranging between 20% and 89%. Thankfully, an 89% decline, such as that experienced during the Great Depression, is extremely unlikely these days. Nevertheless, a minimum decline of 20% has been the expectation when valuations become this extended to the upside.
Image source: Getty Images.
2. History says we're in trouble
History is also pretty clear that investors should be concerned.
Looking back 61 years, there have been nine bear markets. In the previous eight bear markets (i.e., not counting the coronavirus crash), there were either one or two double-digit percentage declines within three years following the bottom. In aggregate, we're talking about 13 double-digit drops spanning the three years following these eight bear-market bottoms.
Without exception, rallies from a bear-market bottom tend be volatile, and they've always included double-digit-percentage corrections or crashes.
Image source: Getty Images.
3. Crashes and corrections happen frequently
Another reason to be concerned about a big drop in the market is the historic frequency of double-digit declines.
According the market analytics company Yardeni Research, there have been 38 separate instances since the beginning of 1950 in which the S&P 500 has retraced by at least 10%. Put another way, we observe an official correction or crash in the benchmark index, on average, every 1.87 years.
Even though the stock market doesn't strictly adhere to averages, it gives us a blueprint of roughly when to expect hiccups in the major indexes. We're now closing in on 15 months since hitting the bear-market bottom in March 2020, and we've yet to experience an official correction in the S&P 500.
Image source: Getty Images.
4. The Federal Reserve can't remain dovish forever
One reason equities have rallied so ferociously off of the March 2020 bottom is the amount of support they've received from the nation's central bank. The Federal Reserve has stood pat on historically low lending rates and continued with its monthly bond-buying program that's designed to weigh down long-term yields.
Here's the thing: This is all going to come to an end at some point. While the Fed has signaled its willingness to allow inflation to temporarily rise above its 2% long-term target, rapidly rising inflation could cause the nation's central bank to act quicker than Wall Street and investors had expected. When the Fed begins tapering its bond-buying program and considers raising lending rates, the music could slow or stop completely for many of the stocks that led the market higher.
Image source: Getty Images.
5. Margin debt is skyrocketing
Perhaps the most terrifying fact of all is the current level of margin debt. Margin is the debt that brokerage customers take on to buy equities. Consider it a way to leverage their gains, as well as their losses, if they're incorrect about which way a stock will move.
As of April, margin debt hit a fresh all-time high of $847.2 billion, per Yardeni Research. For some context, this figure has roughly doubled since 2013. But here's the kicker: A huge spike in margin debt has been observed before both extended bear markets this century. Prior to the dot-com bubble bursting, margin debt rose by more than 80%. Then, before the financial crisis took shape, margin debt spiked by north of 60%. Take note that margin debt over the past year is up more than 60%.
Anytime we see speculators leveraging their bets, bad news soon follows.
Image source: Getty Images.
Crashes beget opportunity
Some of this data might have you feeling a bit bummed out about the near-term prospects for the stock market -- but it shouldn't.
You see, crashes and corrections are the price of admission to one of the greatest wealth creators on the planet. Every single significant drop in the S&P 500, Dow Jones, and Nasdaq Composite throughout history has proven to be a buying opportunity for patient investors. Again, we won't know how long a slump will last or where the bottom will be, but we do know that each of the major indexes are likely to eventually erase all of their declines over time. That means big drops are major buying opportunities.
According to a recently released report from Crestmont Research, the rolling 20-year returns for the S&P 500 between 1919 and 2020 have never been negative. In fact, only two ending years (1948 and 1949) out of the 102 end years examined produced average annual total returns (including dividends) of less than 5%. In short, if you bought an S&P 500 tracking index at any point, you made money as long as you held on for at least 20 years.
As long as you have a long-term mindset, you'll be ready when the next stock market crash arrives.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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