Stock market crash 2.0: a perfect storm is brewing

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It has been a crazy year for Wall Street and investors. Panic and uncertainty caused by the unprecedented 2019 coronavirus pandemic (COVID-19) initially sent the S&P 500 (SNPINDEX: ^ SPX) 34% drop in just under five weeks. The 17 calendar days it took for the index to go from a historic high to a bear market, as well as the roughly four calendar weeks it took for losses to reach over 30%, are both record highs.

However, we also saw the fiercest rally in the history of the benchmark S&P 500. It took less than five months for the index to erase all of its coronavirus crash losses. At the time of writing, it is still higher on an annual basis despite this week’s losses.

Historically, buying stocks during periods of correction has proven to be a smart move. This is because every correction in the history of the stock market has finally been erased by a bullish market rally. If investors are patient and diligent enough to choose large companies, the growth in operating income favors the expansion of stock valuation over time.

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High valuations alone don’t deserve a stock market crash

But after witnessing one of the most violent bearish crashes in stock market history and its subsequent rebound, I can’t help but think that Wall Street is ready to be disappointed.

Many people, including myself, have indicated that the valuation is a reason to worry about a second market crash. Shiller’s price-to-earnings ratio – a P / E ratio based on the inflation-adjusted average earnings of the previous 10 years – currently sits at 33. He has only spent a lot of time above a P / E ratio of 30 three times: just before the Great Depression, just before the dot-com bubble burst, and just before the faded fourth quarter for stocks in 2018. In other words, a Shiller P / E greater than 30 is generally bad news.

Then again, we’ve learned that valuation can be an arbitrary indicator for game-changing companies. Dominant actors in an industry, such as Amazone, Netflix, and Shopify, pay little attention to traditional fundamentals and keep going higher.

In general, the valuation does not sufficiently justify a stock market crash.

This is what a perfect storm looks like for stocks

However, that doesn’t mean the stock market gets a free pass. Right now, three monumental catalysts bode well for stocks. Even with an unusually accommodating Federal Reserve blowing the wind in the sails of the stock market, a perfect storm appears to be brewing that could ravage stocks in the months to come.

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A significant drop in share buybacks and dividends

What does a perfect storm look like for the stock market? First, there are significant declines in corporate buyouts and dividends paid. It’s no secret that common share buybacks have been a key driver of demand for shares over the past decade. In total, Yardeni Research found that cumulative buyouts of S&P 500 companies since the first quarter of 2009 totaled $ 5.63 billion through the first quarter of 2020.

But 2020 is likely to produce the lowest level of share buybacks in years. The Federal Reserve stepped in on big bank buyouts in the third quarter to ensure that financial institutions consolidate their liquidity. Bank of America (NYSE: BAC), which declared a combined $ 26 billion buyback and dividend program in June 2018, has seen only part of its $ 37 billion buyback and dividend program completed since June 2019. Although the Bank of America’s dividend remains intact, only a portion of its nearly $ 31 billion in share buybacks have been completed.

We have also seen dividends being reduced or eliminated altogether. Falling crude prices have forced some shale producers and even integrated oil and gas giants (for example, BP), to reduce or stop their dividends. The same could be said of the airline industry, where virtually all airline stocks have suspended their dividends and share buyback programs.

Without these shareholder benefits, demand for shares could slow significantly in the coming quarters.

A pile of hundred dollar bills and messy stimulus checks next to the Capitol building.

Image source: Getty Images.

A lack of stimulus money

While Wall Street doesn’t seem to care too much about the ongoing stalemate in Washington due to another round of coronavirus stimuli, it should be concerned.

While the stock market shows pockets of strength in cybersecurity, telemedicine, and just about anything cloud computing, the heart of the US economy is built around consumerism. In fact, about 70% of America’s gross domestic product depends on consumption. Unfortunately, consumerism is precisely what is threatened by the current halt in stimulus measures on Capitol Hill.

At the end of July, the improved unemployment benefits ended. The bonus provided an additional $ 600 per week to the unemployed between April 1 and July 31. While this additional benefit was never intended to be permanent, it was also granted on the assumption that the economic recovery in the United States would be rapid. It was not the case. The 10.2% unemployment rate in July 2020 is higher than it was at any time during the Great Recession, and is reminiscent of the stable double-digit unemployment rates last seen in the 1930s.

These improved unemployment benefits, along with the economic impact payments that were sent in April and May, have helped prevent rental evictions, foreclosures, credit arrears and other problems. With these sources of stimulus now gone, tens of millions of Americans could soon face serious financial crises that will have a profoundly negative impact on consumption.

A stack of invoices stamped with the words Overdue and Final Notice.

Image source: Getty Images.

A maelstrom of the financial sector

The final piece of the puzzle is that the financial sector is in danger of falling apart.

While it is true that financial institutions are much better capitalized than they were in the Great Recession, bank stocks are going to be hit on both sides once the unemployed and consumers really start to feel the spur of the moment. ‘no additional stimulus. On the one hand, the Federal Reserve’s promise to keep lending rates at or near historically low levels over the next two years will limit the interest income potential of banks. On the other hand, the reduction in earning capacity is likely to lead to a surge in delinquency on loans in the coming quarters.

We really don’t know how bad things could turn out in the United States. In August, the Mortgage Bankers Association reported that the mortgage default rate on residential properties with one to four units rose 386 basis points from the first sequential quarter, accounting for 8.22% of all loans in course at the end of the second trimester. This is the largest quarterly increase since the MBA began tracking loan delinquencies in 1979.

We also entered 2020 with auto loan delinquencies reaching their highest level since 2011, according to the American Bankers Association. Auto loans don’t create much of the same financial problems as delinquent mortgages, but a continued increase in auto loan delinquencies could hurt bank results.

The financial sector is often touted as the backbone of the US economy. If it weakens even more than it already is? Look for stocks below.



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