Is a Stock Market Crash Inevitable?
Since the bottom of the financial crisis, the S&P 500 index has returned over 1,000% on a total return basis.
The massive recovery we have experienced over the past 15 years is remarkable and has left many investors wondering when the next drop will happen. It may seem inevitable to you. And if history is any guide, it is inevitable. But that doesn’t make it predictable. Beginning in 1994, valuations looked stretched, and many Wall Street veterans started calling for a correction. We now know this was very premature, and stocks more than tripled before eventually plummeting.
This is the most classic example of the differences between inevitable and predictable. Today’s market is not comparable to the tech bubble, with more reasonable valuations and strong earnings growth. However, valuations look a little expensive compared to their historical averages (21.5x vs. 16.7x average).
As a counterpoint, earnings continue to grow at a much faster rate than their historical averages, which may justify higher prices. The point is we don’t know. If we believe valuations will eventually return to their historical norm, which is not guaranteed, consider the various (entirely made-up) ways we could get there over the next five years (2025-2029).
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Scenario 1 (good returns, better earnings): 10% stock returns per year and 15% earnings growth.
Scenario 2 (a minor correction now): -15% stock returns in 2025, 10% stock returns per year after that, along with 9% earnings growth.
Scenario 3 (massive bear market later): 10% stock returns and 7% earnings growth for the next 4 years, and then a 25% bear market in 2029.
Scenario 4 (muted returns for 5 years): 4% stock returns per year and 9% earnings growth.
Any of these scenarios results in the stock market's valuation (price to earnings) going from today’s mark of 21.5x to the long-term average of 16.7x by 2029.
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The list could go on indefinitely, and it's doubtful that the future will match any of the four scenarios above. However, these examples highlight how challenging it is to predict market returns, even if you believe, for instance, that "stocks are overpriced."
Is a market crash on the horizon? Maybe. But maybe not. We could see earnings grow, making share prices seem more reasonable. We could see a few years of below-average returns with no significant downturn. Stocks could get more expensive over the next few years before eventually falling. Or, we could have a market crash start tomorrow - those happen occasionally. Since the future is uncertain, the best approach for retirement investing is a blend of long-term optimism and cautious awareness of the potential short-term risks by having the money you will need soon, not subject to the stock market volatility.
Happy Planning,
Alex
This blog post is not advice. Please read disclaimers.