Stock Market Poised for Crash?
Admittedly, with the S&P 500 and Dow Jones Industrial Average trading at record-highs, the idea of a stock market crash isn’t garnering much attention. But despite the euphoria on Wall Street, the pieces necessary for a crash are in place.
And investors need to know how to protect themselves from an impending stock market crash. Because if there’s one thing we know about the stock market, it’s that it goes in cycles. Bear markets turn into bull markets, and eventually they correct or crash and investors run for the exits. But they always come back. Optimism seeps in and a bull market emerges.
We know this happens because the stock market is at record-highs just six years after it tanked in 2009, erasing almost 15 years of gains and plunging the global economy into a recession.
The current bull market (the fourth longest since 1928) began in March 2009 and is closing in on 2,200 days. For those keeping track, the average S&P 500 bull market lasts just 933 days.
The Great Recession: The Housing Bubble Burst
The roots of America’s last stock market crash can be traced back to 2006, when the U.S. housing market topped in March. Twelve months later, the housing bubble burst, dragging the U.S. economy down with it.
The Great Recession lasted for 18 months. Over that time, the S&P 500 lost more than half its value by the time it bottomed on March 6, 2009 at 666.79. The New York Stock Exchange (NYSE) fell 60%, while the Dow Jones Industrial Average and NASDAQ shed more than 50%.
One of the most notable corporate collapses that resulted from the Great Recession was Lehman Brothers. The banking giant held a significant portion of its investments in housing-related assets. This made it extremely vulnerable to any pullback in U.S. housing.
On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman’s bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants, such as WorldCom and Enron. Over a relatively short period of time, the company’s share price plunged from approximately $25.00 per share to $0.15 per share.
Another casualty, one that survived its brush with disaster, is General Electric Company (NYSE/GE). In October 2007, GE was trading above $32.00 per share; by March 2009, the company’s share price had lost more than 85% of its value, trading for as low as $4.77 per share. GE Capital, a subsidiary of GE, expanded its mortgage lending as the housing bubble inflated. This move left the company exposed when Lehman Brothers collapsed. The company’s share price has since rebounded and is currently trading around $25.00 per share.
Signs of a Bull Market Crashing?
There’s more behind the notion of a stock market crash than just bear/bull statistics. The current bull is getting long in the tooth by anyone’s standards. While some bulls continue to be optimistic, it’s important to remember that previous bull markets have been fuelled by strong fundamentals and earnings. That’s not the case this time around.
The fact of the matter is that the current bull market has been fuelled by the Federal Reserve’s overly generous bond-buying program. Three rounds of quantitative easing and artificially low interest rates have sent the stock markets into the stratosphere. Since bottoming in March 2009, the S&P 500 has soared 215%, while the Dow Jones Industrial Average is up an impressive 180%.
But behind those staggering gains are plenty of financial engineering and less-than-stellar quarterly results. By “financial engineering,” I mean using share repurchase programs to boost earnings.
In the third quarter of 2014, companies on the S&P 500 spent $143.4 billion on share repurchases, a year-over-year increase of 16%. On a trailing 12-month basis, those same companies spent $567.2 billion on share repurchases, a year-over-year increase of 27%.(1)
Companies on the S&P 500 need to maintain the same pace if they’re going to appease investors. For the first quarter of 2015, 80% of companies that have issued earnings guidance have announced a negative outlook.(2) In September 2014, the estimated earnings growth rate for the first quarter of 2015 was 9.9%. It now stands at -1.6%.
While companies struggle with actual earnings growth, their share prices climb higher. There is an obvious disconnect. After all, the stock markets are only as strong as the stocks that make them up. And for a country that gets roughly 70% of its gross domestic product (GDP) from consumer spending, U.S. stocks are being stretched thin.
U.S. wages are stagnant and Americans are saddled with growing personal debt. Unemployment numbers might look good at 5.7%, but the underemployment rate is still unacceptably high at 11.3%.(3) And a staggering number of Americans continue to receive food stamps.
In October 2014 (the most recent data), more than 46.67 million Americans (15% of the population), or 22.86 million households, received food stamps. Since the stock market rebounded in 2009, food stamp usage has increased more than 24%.(4)
Protecting Yourself from a Stock Market Crash
There are a number of different strategies investors can take to protect their portfolio from an eventual stock market crash or correction. The following four suggestions can get you started on the right track.
Inverse Index Funds
Those who think the markets are ripe for a correction can consider ETFs (exchange-traded funds) that short the different exchanges.
For example, the ProShares UltraShort Dow30 (NYSEArca/DXD) seeks results that correspond to two times the inverse (-2x) of the daily performance of the Dow Jones Industrial Average. The ProShares Short S&P500 (NYSEArca/SH) seeks a return that corresponds to the inverse (-1x) of the daily performance of the S&P 500. And the ProShares UltraPro Russell2000 (NYSEArca/URTY) seeks daily investment results that correspond to three times (3x) the daily performance of the Russell 2000 Index.
But you don’t need to limit yourself to inverse ETFs that just track American stocks. The Direxion Daily FTSE China Bear 3X Shares (NYSEArca/YANG) seeks daily investment results of 300% of the inverse of the performance of the BNY China Select ADR Index.
Defensive Dividend Plays
To shield yourself from any correction, you might want to research defensive stocks. Boring consumer product, food, utility, and tobacco companies with a long history of providing annual dividend growth and capital appreciation become a lot less boring when the markets start to teeter.
Investors can either look at individual defensive stocks, like Johnson & Johnson (NYSE/JNJ) or Altria Group, Inc. (NYSE/MO), or consider ETFs, like the iShares US Consumer Goods (NYSEArca/IYK), PowerShares DWA Consumer Staples Mom ETF (NYSEArca/PSL), or the Guggenheim Defensive Equity ETF (NYSEArca/DEF).
If stocks are undervalued, buy; if they’re overvalued, short. Those who think valuations are too high could always consider selecting a small basket of stocks they think would be vulnerable to a market-wide sell-off.
If you’ve made solid gains over the last few years and are nervous about the market at all-time highs, take profits. Trim a comfortable amount from your positions. Not only will this allow you to lock in profits, it also frees up capital to buy new stocks for when the correction comes.