The Next Stock Market Crash?

With stock markets at near record levels and good question to ponder is when or how will the next share market crash happen?

Is it the moment interest rates start to turn?

Or of one or two world events e.g.  Brexit combined with faster virus infections?

An interesting pce exploring this from Seeking Alpha 

The Next Stock Market Crash Is Rooted In This Cognitive Misconception

Dec. 18, 2020  The European View

Summary

Cheap money and ever-rising stock markets naturally lead to a correction or even a crash because until now, every party has ended at some point.

The frivolity and emotions of many investors could accelerate the fall in prices. Much of this might be avoidable.

In my view, the problem is a widespread and increasingly spreading cognitive distortion.

With a change of perspective among many investors, the focus has shifted significantly from investing in speculation.

Introduction

Investors are trapped in a dilemma. Many multiples point to an overvaluation of the market on a broad front. For example, look at the Shiller P/E ratio, an inflation-adjusted comparison of the stock price with the average ten-year earnings. Higher than now, investors valued the S&P 500 only at two points. One was before the Great Depression and the other when the tech bubble burst.

Data by YCharts

Conversely, investors also know that it is best to stay invested statistically speaking because you cannot predict the market. Additionally, the current market phase is, in my view, characterized by fear and greed. There is certain greed in the markets, as the CNN Fear & Greed Index showed us recently. While the index is very volatile, the Fear & Greed Index correlates with corrections or crashes even if it cannot predict these events' strength.

On the one hand, there is greed for wealth as quickly as possible. On the other hand, there is the fear of missing out on the wealth that the others could achieve. And with every percent that these stocks rise, a self-fulfilling prophecy manifests itself.

Conversely, we also know that every party will find its end at some point. And most of the time, it was always the case that the volume of the party music correlated with the bang's magnitude. There has never been a "this time everything is different." Therefore, it is unlikely that it will be different this time. However, I fear that investors' frivolity could accelerate the correction or crash (whenever it comes). Responsible for this is a cognitive distortion, which I would like to describe in more detail below.

The perspective has changed

In my view, investors are making one of the worst mistakes. It took me a while to understand why investors buy companies with such airy multiples. It was a conversation with a colleague who told me that he purchased Amazon because he expects the price to rise. However, this was not based on the idea that the price would increase because Amazon is growing enormously, and multiples like P/E ratios are not very meaningful here because the company deliberately does not want to make a profit.

Behind this purchase decision was simply the expectation that the price will rise. For me, who wants to become an owner of companies and therefore wants to get a substance for his money and not just a coupon that might increase in value, this consideration was new. In this respect, the perspective has changed. A share is no longer the proof of ownership of a company but a kind of betting slip with which one can bet that share prices will rise. With this change in perspective, the focus has shifted significantly from investing to speculating

The cognitive misconception

One of the reasons for this change of perspective is a cognitive misconception, which I have recently encountered more often, especially in some of my articles' comments. Some investors confuse a company's success with a good investment and establish a kind of necessary causality between these two poles.

You must make a clear distinction between an investible company and a good investment. Just because a company is successful, grows, and generates better earnings and cash flows, it does not automatically become a good investment. The question is how much you have to pay to become the owner of these profit and cash flow machines.

Apple for example, is an excellent company, and I predict great prospects for them. The transformation from a pure hardware company to an integrated service giant with good prospects in the healthcare segment has been successful. This development was already foreseeable many quarters ago, and the reason why I put Apple in my portfolio. So Apple has an investable business model. But does that also make Apple a good investment?

Fundamentally, Apple was undervalued for almost ten years and offered investors an excellent opportunity to increase their shares in the company over the long term. That has changed in the meantime. Look at how Apple has grown since the COVID crash. Is the company different now than it was a year ago? Have the fundamental prospects of the company changed? Why is the company today worth more than 80 percent more than it was a year ago? There are no rational reasons for this.

Fair value calculation Apple, Source: DividendStocks.Cash

Also, Nvidia is such a "Chase the Runner" stock. The company is exceptionally well-positioned in future markets. 5G, the ARM acquisition and the tailwind of the expected growth in the cloud market will ensure that Nvidia will massively increase revenues, cash flow, and profits in the coming years. 

A third company is Microsoft (MSFT). And it is precisely here that I find it fascinating how investors fade out what the dot.com bubble burst made with the stock. It has been shown in an almost exemplary manner that growth does not necessarily correlate with rising share prices. The company grew from 2002 to 2016 at a respectable pace.

Microsoft revenue & EPS from 2002-2016; taken from MSFT investor relation/graph by author

But there was not much left for investors. Investors who bought the stock at the peak of the tech bubble suffered book losses of 60 percent. It took a full 15 years for the share price to break-even again. Right now, the stock has also massively departed from its fair values and is trading almost 30 percent above appropriate values based on adjusted earnings expectations for 2023.

Dividend stocks that are worth a second look

So how can one escape from this dilemma? I think it is difficult. On the one hand, we see the massive stock price developments. On the other hand, we have a terrible feeling about playing this game. It would also be wrong to keep your hands off the tech stocks because there is no denying that they will play a significant role in shaping our future. Those who think long term and have an investment horizon of 15, 20, or 30 years should also be able to sleep soundly despite the high valuations. Microsoft, in particular, has seen that such companies do not disappear despite overvaluation. Even overvalued shares can, in the long run, grow back into fair valuation and justify higher prices. It may just take time.

Conclusion

The potential of the next correction or stock market crash could be substantial. Additionally, the destructive potential shifts from the financial world to society's social world because retail investors have a lot of skin in the play.

In many ways, the retail investor has become a more powerful collective force than the professional investor, and they simply don't care about the same things as the experts.

In fact, individual investors now account for roughly 20% of stock-market activity on average and nearly one-quarter of trades on peak days, according to Joe Mecane, the head of execution services at Citadel Securities. The firm is the leading retail market maker in the U.S., handling 40% of the shares and options traded by individual investors.

The retail bros also don't care about traditional parameters of valuation (P/E and P/S ratios) and could always trade out of a stock for free because of commission-free trading.

This scenario combined with a wrong investment approach can increase the severity of the correction. Investors should, therefore, strictly adhere to their risk allocation rules. Besides, it is advisable to look more closely at fundamental data and speculate less solely on further price increases.