The coronavirus crisis and the US election have driven fears of a major market crash to the highest levels in many years.
At the same time, stocks are trading at very high levels. That volatile combination doesn't mean that a crash will occur, but it suggests that the risk of one is relatively high. This is a time to be careful.
I base these conclusions largely on research I've been doing for years, including findings from the stock market confidence indexes that I began to develop more than three decades ago. These indexes are drawn from surveys of a random sample of high-income individual investors and institutional investors in the United States that are now conducted monthly by the International Center for Finance at the Yale School of Management.
Consider what my Crash Confidence Index is telling us. That measurement of sentiment about the safety of the stock market is based on this question:
"What do you think is the probability of a catastrophic stock market crash in the US, like that of Oct. 28, 1929, or Oct. 19, 1987, in the next six months, including the case that a crash occurred in the other countries and spreads to the US?"
The index is a rolling six-month average of the percentage of monthly respondents who think that the probability of such a major crash is less than 10 per cent. In August, the percentage of individual investors with that level of confidence in the market hit a record low, 13 per cent. The most recent reading in September, 15 per cent, was still extremely low.
Institutional investors — people who make decisions for pension funds, mutual funds, endowments and the like — were a bit more confident, with a September reading of 24 per cent, but that was extremely low, too. In short, an overwhelming majority of investors said there was a greater than 10 per cent probability of an imminent crash — really, a remarkable indicator that people are quite worried.
Another of my stock market confidence indexes, the Valuation Confidence Index, is also near a record low in 2020. It is based on this question: "Stock prices in the United States, when compared with measures of true fundamental value or sensible investment value, are: 1. Too low; 2. Too high; 3. About right; 4. Do not know."
This index tells us the proportion of investors who think the market is not too highly priced. At the latest measure in September 2020, the reading for individual investors stood at 38 per cent, far lower than at the bottom of the stock market in March 2009, when it stood at 77 per cent after the financial crisis. For institutional investors, it was 46 per cent in September, compared with 82 per cent in March 2009.
Despite these signs of distress, the stock market has been trading near a record high, stretching the valuations of stocks to fairly rich levels. That's very different from the situation in March 2009, when stock valuations were quite low and the stock market subsequently rose. It is a different situation now, however: Not only is investor confidence low, but actual stock valuations are quite high.
Consider a separate measure of stock valuations that I helped create — the Cyclically Adjusted Price Earnings (CAPE) ratio. This is a measure that enables the comparison of stock market valuations from different eras by averaging the earnings over 10 years, thus reducing some of the short-term fluctuations of each market cycle. It now stands at a level that was higher in only two periods, both of which were followed by stock market crashes: the 1920s, in the lead-up to the Great Depression; and early 2000, just before the bursting of the dot-com bubble.
The low confidence readings and the high stock prices won't, on their own, cause a market crash. Another dynamic would need to be in effect.
It seems that when superficial similarities to current events prod people's memories, they shift their attention to old stories. The question now is whether another reminder of crashes past could emerge to create a psychological sense of the risk. A further pickup in coronavirus cases, a chaotic or violent election or any number of other events could well shake people up. Conversely, an orderly election, and a sense of political and economic stability, could have a calming effect.
We may be at something of a crossroads.
The decision to invest in the stock market is for some people a bit of an adventure. One is goaded to do it partly by the fun of it and partly by a competitive spirit in observing others and wanting to keep up. The market may be vulnerable to a change in mass psychology, one that might dampen this sense of adventure and bring on a crash.
It seems that investors should be advised to remain cautious in their US stock market holdings. The potential rewards for being heavily committed to the market in the coming years need to be carefully balanced against the possible risks.
No one knows the future, but given the general lack of investor confidence amid a pandemic and political polarization, there is a chance that a negative, self-fulfilling prophecy will flourish. This highlights the importance of being well-diversified in asset classes — including Treasury securities, which are safe — and not overexposed to US equities now.