Anyone Who Thinks We Need A 'Catalyst' For A Market Crash Should Brush Up On Their History

stock market crash 1929
There was no "catalyst" in 1929. Or 1966. Or 1987. Or 2000. Or 2008...
Hulton Archive /Getty Images

The stock market continues to push higher, on route to posting one of the best years in history.

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This advance comes in the fifth year of recovery from the financial crisis, and it has seen the S&P 500 nearly triple off its low of March, 2009.

These years of gains have gradually made investors more comfortable again, and now there appears to be a widespread consensus that it's finally "safe" to own stocks.

I own stocks, so I'm certainly enjoying the advance. But unlike some other investors, I'm not feeling more comfortable as they move higher. Rather, I'm feeling less comfortable.

Why?

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Because I do not think that time-tested market valuation measures have recently become out-moded and irrelevant. As I've described, these valuation measures suggest that today's stock prices have gotten so extreme that returns over the next decade are likely to be lousy (less than 2% per year, including dividends). So that's what I'm expecting long-term stock returns from these prices to be.

Now, valuation is not helpful as a market-timing tool, so today's prices do not mean that stocks will crash anytime soon (or ever). Instead, stocks could deliver lousy returns just by moving sideways for a decade.

But anyone who has followed the stock market for a while knows that stock prices do not generally correct valuation extremes by moving sideways. Rather, stocks generally correct sharply.

That's why I've said I think the odds of a market crash are increasing.

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And I still think that — more so with every new move up.

Even among investors who are as concerned as I am about long-term valuation measures, however, there is one consistent argument about why there won't be a crash:

"There's no catalyst."

Specifically, even cautious investors are concluding (or, at least, hoping) that, because they can't identify what will cause a crash, there won't be one.

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And maybe there won't be one.

But I can promise you this: If there is no crash, it won't be because investors can't currently see any "catalyst."

One of the biggest mistakes investors make when it comes to trying to time market turns is in thinking that there will be a clear "catalyst" or "sign" ahead of time that tells them when the market is about to turn.

The truth is that there almost never is.

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There are plenty of catalysts and signs in hindsight, of coursewhen historians sift through the wreckage and, with the benefit of knowing how things turned out, list all the obvious factors that idiot investors ignored or missed. But, these catalysts and signs are almost never obvious at the time.

(I speak from experience here, by the way. Towards the end of the dotcom bubble in the late 1990s, I was aggressively looking for a sign or "catalyst" that would tell me that it was finally time to lock in the extraordinary gains of the prior five years and head for the sidelines. And so were other investors who had a lot more experience than I did. But this sign, unfortunately, never came — until after the fact. After the fact, as always, it seemed screamingly obvious that the market was about to break down in the spring of 2000 and then, after a confidence-restoring headfake that summer and fall, erase several years of gains in a final, brutal two-year plunge. But most of the warning signs that were visible in 1999 and early 2000 had been visible for years, and that hadn't stopped the advance.)

Today's stock market is nowhere near as overvalued as the one in 2000. And, thankfully, we have not yet reached a price at which long-term stock returns are likely to be negative.

But even those who think that stocks have much farther to run should stop assuring themselves that the market won't crash because there's no visible "catalyst."

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Markets don't need a visible "catalyst" to crash.

They just need a minor change in sentiment.

Once stocks start going down, the enthusiasm for buying them at any price will rapidly cool. And the giddy investors who have recently piled up massive levels of margin debt to buy more stocks will rethink the wisdom of this. And the small investors who, finally, after five years of missed gains, have become comfortable enough to put money back into the market will suddenly start to focus on the downside again. And so on.

One investor who has long been concerned about the risk of a crash is John Hussman of the Hussman Funds. This cautious stance, of course, has caused Mr. Hussman's funds to underperform badly over the last several years and, as a result, has led many of today's vocal bulls to dismiss him as a moron.

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You can view Mr. Hussman as a contrary indicator if you like (at your peril — he's one of the most disciplined analysts around), but at least listen to what he and others have to say about "catalysts":

The immediate objection, of course, is that one does not observe an obvious “catalyst” that would warrant a market decline, much less a crash. As I wrote about our defensive stance during the 2000-2002 decline, “Our positions are always built on observable evidence rather than scenarios. We already have sufficient evidence to be fully defensive. Only later will we read in the headlines exactly why this defensive position was warranted.”

As I noted again approaching the 2007 market peak, the need to wait for some observable “catalyst” to justify a defensive stance is reminiscent of other awful consequences of overvalued, overbought, overbullish, rising-yield syndromes, including the 1987 crash: “Investors could find no news to explain the crash in that instance, except an unusually large trade gap with Germany, so they continued to fear that particular piece of data. But day-to-day news events rarely ‘cause’ large market movements… Once certain extremes are clear in the data, the main cause of a market plunge is usually the inevitability of a market plunge. That's the reason we sometimes have to maintain defensive positions in the face of seemingly good short-term market behavior.”

Sornette described this same regularity a decade ago: “The underlying cause of the crash will be found in the preceding months and years, in the progressively increasing build-up of market cooperativity, or effective interactions between investors, often translated into accelerating ascent of the market price. According to this “critical” point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. Essentially, anything would work once the system is ripe… a crash has fundamentally endogenous, or internal origin.”

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Again, I own stocks, so I certainly won't be unhappy if the market just keeps powering higher.

But I only own stocks because I am comfortable with the idea that the market might drop 40%-60% over the next year or two. If the market does that, I will buy more stocks, just the way I did during the crash of 2008-2009. (I didn't buy enough stocks during this decline, unfortunately. Because, in part, I was stupidly waiting for a clear "sign" or "catalyst" for the upward turn.) 

If you are not comfortable with the idea that stocks could drop 40%-60% over the next couple of years, you should think carefully about how you will feel and behave if they drop, say, 20%-30% (a garden-variety bear-market pullback). And if you conclude that a pullback like that would suddenly dampen your enthusiasm for owning stocks, you might think about re-balancing your portfolio now rather than then. Otherwise, you'll risk making the same mistake that far too many investors made in 2008 and 2009 — selling near the bottom.

But, regardless, don't waste your time looking for a "catalyst." Chances are, you won't see one until it's too late.

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SEE ALSO: I Won't Be Surprised If The Stock Market Crashes Next Year — And You Shouldn't Be, Either

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