- The financial markets recovered quickly from the crash in March last year.
- However, there are several experts who warn us for another potential market crash in the near future.
- Arguments for this are too much optimism of investors and similarities of the situation before the dot-com crash.
Market crashes from time to time are inevitable, since there always will be unexpected circumstances which negatively affect the stock market. Add some panic behaviour of investors to it and before you know it the stock market shows a major decline. But how could there be a crash in the near future when we already had one in March last year? Furthermore, why would there be a market crash while it seems that the world is slowly recovering from the pandemic with extensive vaccine programmes everywhere.
To understand the danger of a potential market crash, it is actually a good starting point to take a look at the characteristics of the last major drop in March 2020. This crash was a completely logical one, COVID-19 has spread to every continent, governments set out huge sets of restrictions and the global economy slowed down heavily. This caused a decrease of at least 20% for every major index. Surprisingly, the financial market recovered fully by the end of 2020, while the global pandemic is not over yet. Does this mean that the pandemic was not so harmful for the economy after all, or are investors perhaps too optimistic? The International Monetary Fund (IMF) warns us for the dangers of the last-mentioned situation.
According to the IMF, the current situation on the financial market has striking similarities with the situation just before the crash of the internet bubble in 1999. It seems that the willingness to take risk of investors is endless. One example of this is that several corporations who are making losses every year can still triple in value. The reaction on news related to COVID-19 also seems to show a pattern of optimism. Negative news, for example related to stricter rules or an extended lockdown, does not seem to affect the market much. According to the IMF, it seems that investors trust on the supporting government policies and that these policies will be effective enough to tackle all the problems of the economic uncertainty we have to deal with today. On the other hand, positive news related to COVID-19 immediately has a positive effect on share prices.
Grantham is particularly concerned about the US equity bubble and predicts a burst in the upcoming months or even weeks.
Next to the IMF, there are others who warn for a major decline in the financial markets. One of them is Jeremy Grantham, who has correctly predicted the path of the bubbles related to dot-com and housing overvaluations. He is particularly concerned about the US equity bubble and predicts a burst in the upcoming months or even weeks. This prediction was already made at the end of October in 2020 and has not come out as true yet. Of course, it is hard to tell if he is wrong or just not right yet. To indicate that everything is overpriced, Grantham highlights the price to earnings ratios of today. These are at the highest 15% of their historical values, which does not seem in line with the current uncertain economy. High price to earnings ratios rely on investor confidence, when this confidence is broken because of disappointing results, serious declines will follow. Grantham predicts that this is what will happen and his investment recommendation therefore is to invest in emerging markets and avoid US equities as much as possible.
Lastly, there is Robert Buckland who warn us about the current situation of the financial market. Although he seems less pessimistic than the IMF and Grantham. When we for example look at the Nasdaq and S&P index, we can observe that they rose 83% and 36% in the last three years. This can be interpreted as bubble like increases. However, compared to the 285% and 93% increases between 1997 and 2000 just before the dot-com crash, the threat of a bubble about to burst seems less likely. This means that if valuation were to hit previous peaks, US equity indices could possibly rise another 100% before a burst would happen. Buckland argues that we should be careful with statements as “this crazy bubble will burst soon.” Namely, bubbles do not burst at the first sign and take some stopping.
In the end it remains difficult to decide how big the treat of market crash actually is. When looking at the arguments of Grantham and the IMF, we should be really careful and believe that especially US indices are following bubble like patterns. On the other hand, it could be that the optimism of investors will be confirmed in the future, justifying the high current price to earnings ratios. Nevertheless, it is probably a good idea to not go all-in on US indices and in this way reduce exposure to bubble like equity markets.