A trade works on the floor of the New York Stock Exchange, Thursday, Dec. 11.Richard Drew/The Associated Press
What are the chances of the stock market crashing over the next year? It’s a question every investor should periodically ask. The answer allows you to gauge your own level of anxiety. Better yet, it allows you to compare your perceptions of danger with the assumptions that are embedded in the market.
Right now, the market’s assumptions and yours may be miles apart. Judging from surveys of consumer sentiment, many Main Street investors have butterflies in their stomachs. They are convinced a market crash is nigh. (Full disclosure: I share some of those anxieties.)
Oddly, though, the high level of anxiety isn’t reflected in many sophisticated indicators. For the most part, Wall Street experts are still upbeat about what lies ahead.
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How big is the gap? Consider a recent survey by Victor Haghani and James White of Elm Wealth, a Philadelphia-based money manager for high-income clients. They asked the ordinary folk who read their research bulletins what they thought the probability was of the U.S. stock market dropping 30 per cent or more over the next 12 months.
The 2,792 people who responded to the survey estimated, on average, that there was a 30.5-per-cent chance of such a debacle. That is strikingly high. If Elm Wealth’s readership is anywhere near accurate, we should all be rushing for shelter.
Yet, as Mr. Haghani and Mr. White point out, it’s difficult to see how the hard data can justify this level of fear. History suggests that major market declines are rare events. Even when stock market valuations are as high as they are now, the historical probability of a market crash in any given year ticks up to only about 10 per cent.
This modest level of risk is pretty much in line with what other financial indicators are signalling. Look at the options market, for instance. If big-money investors were losing sleep about the possibility of a stock market catastrophe, they would be snapping up “put options” – specialized contracts that would allow them to benefit from the coming crash by selling securities at preset high prices. Yet the current prices on such options suggest the pros think there is only about an 8-per-cent chance of a major market fall over the year ahead, according to Elm Wealth.
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The confidence on display in the options market is in keeping with the upbeat commentary from major money managers and investment banks. Bank of America Corp. forecasts that the S&P 500 will edge up from its current level around 6,800 and hit 7,100 in 2026. Citigroup Inc. says the index will surge to 7,700. Meanwhile, the cheerful crew at Deutsche Bank AG declare it will rocket to 8,000.
Granted, this display of optimism may be happy talk designed to encourage prospective clients. However, it’s not entirely fanciful. Just ask the bond market – it is typically a sober judge of financial risk, and it remains unusually confident.
To gauge that optimism, measure the difference between the yields on risky high-yield bonds and those on supersafe government bonds. This difference, or spread, usually soars when the market sees signs of trouble ahead, because investors in high-yield bonds start to demand extra payoffs to shelter them from the growing probability of loss. Right now, though, high-yield bond spreads are still at some of their lowest levels in a generation. Bond investors aren’t seeing many clouds in the sky.
Rational investors have to acknowledge these upbeat signals. For all the excellent reasons to worry about the long-run outlook for the stock market – sky-high valuations, runaway fiscal deficits, the frenzy around artificial intelligence – the hard evidence suggests the chances of a market crash over the next few months are actually rather low.
So what should an investor do?
They should balance risk and reward. Among other things, that means realizing that caution may not be rewarded immediately. This bull market could have further to run.
However, it also means not getting too tied up in the here and now. Remember, it’s not just the possibility of an unexpected crash over the next few months that should concern you – it’s the cumulative possibility of an unexpected crash over the next few years.
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The potential rewards for sticking around this frothy market are shrinking. Torsten Slok, chief economist at investment giant Apollo Global Management, points out that the return you can expect to reap from stocks grows smaller as the market’s price-to-earnings ratio climbs higher. “The historical relationship between the S&P 500 forward P/E ratio and subsequent 10-year annualized returns shows that investors should expect to get zero in return in the S&P 500 over the coming decade,” he recently wrote.
All of this suggests that Main Street investors are wise to edge toward safety. No, that doesn’t mean abandoning the stock market. But it does mean building up a significant buffer of safer assets, such as bonds and cash, just in case. The time-honoured 60-40 portfolio mix holds 40 per cent of its value in bonds, and that seems like quite a reasonable target for most of us.
If the 60-40 blend strikes you as being too conservative, remember that Warren Buffett is now holding in excess of US$350-billion in cash. The great investor seems to see solid reasons to avoid today’s stock market and wait for a better buying opportunity. There is nothing wrong with sharing his opinion. To be sure, the current indicators suggest you may have to wait a while for that buying opportunity to emerge. But when it does, you’ll be ready.