Should you be fearful of a stock market crash?

A broker reacts as U.S. President-elect Donald Trump shows up on a television screen at the stock market in Frankfurt, Germany, Nov. 9, 2016. (Photo: Michael Probst/AP)
(Photo: Michael Probst/AP)

There is little that can impact your investing wealth more rapidly than a stock market crash.

Given the wondrous returns from most equity and bond markets since the 2007-2009 global financial crisis, we are overdue a correction, especially as recent history has seen such muted volatility in leading global bourses.

Note the wailing and gnashing of teeth earlier this week after the failure of the US S&P 500 index to rack up a 110th successive day of not falling 1%. You don’t need significant grey hair to remember when a 1% fall was just a ‘bad day on the markets’ and not something for copious panicky analysis.

Fear and greed

These are the challenges of financial markets however. A stock market cycle is always significantly more volatile than an economic cycle because of two of the most influential words in finance: ‘fear’ and ‘greed’.

Investors have been spoilt in recent years – and memories of the deeply volatile stock markets over just under a decade ago have wilted from the collective memory of financial market participants. This has been aided and augmented by the policy response from the world’s central bankers which focused on stimulus led by ultra-cheap money: great for your monthly mortgage repayment level but also highly influential in channelling more and more money into equity, bond and other asset classes including, of course, property.

Now you can justify higher financial markets with cheap money. The competitive attractions of cash in the bank are diminished and it should reduce costs and investment hurdles for businesses. However, you can only get so far away from what calmer investors would call ‘fundamentals’ like company earnings and cash flow generation and what you pay as an investor for the profit and dividend flow from owning a share or the extent of the coupon payments from owning a bond.

An event catalyst

Today, it is increasingly hard to argue that investors are being sensibly compensated across financial markets versus historic norms. Not that this has stopped recent big inflows into index tracking mandates which themselves have performed well because of market momentum. All it seems we are missing is the shoe shine boy – or a taxi driver or supermarket cashier – to launch unprompted into a quick monologue about the attractions of near-term investing.

You always need an event catalyst. Higher interest rates would certainly be a headwind but outside of a little bit of fiddling around by the Federal Reserve in the United States, other big global Central Banks seem to be keeping their cheaper money policies for now despite a bit of inflation in the system. Ironically this may induce greater enthusiasm for equities versus bonds in the shorter-term.

How about the corporate earnings side? Certainly, President Trump may disappoint on his growth plans, China may struggle with their ongoing economic transition and/or a combination of Brexit fears and European Union economic sclerosis could impact. And then of course there are the slower moving but clearly problematic issues of high global debt levels and ageing populations.

Hope for the best and prepare for the worst

If you bring it all together there clearly is far too much enthusiasm for financial markets currently given the reaction to a minor pullback in the US bourse earlier this week. And as night follows day fear will trump greed at some point and will feed on itself influenced by one or more of the issues above…or something else entirely different. It is going to happen, and it is closer than two or three years ago.

Warren Buffett famously noted that he could not understand why lower prices in the world’s financial markets did not induce the same enthusiasm as lower prices in a shop or on an auto forecourt. That’s the wealth effect for you, combining with natural human psychology. Any investor though has to prepare themselves for this eventuality. This is not just pressing the buy button when various shares or a stock market index is down a certain percentage but the far more important preparation of knowing why you own something. The biggest mistakes come not from the in hindsight ludicrous investments that are made in times of greed.

So today hope for the best – it might just happen! – and prepare for the worst. If you don’t understand or feel totally comfortable with what you are investing in then look to sell it now.

As John Paul Getty famously once said when asked how he got rich: ‘it was by selling too soon’.

Chris Bailey has over 20 years of investment industry experience at long-only and long-short institutions as a global multi-asset fund manager, strategist/macro thinker and, in the earlier part of his career, as a securities and fund analyst.

In 2013 he founded Financial Orbit focusing on daily macroeconomic comment and securities analysis. In December 2016 his Twitter account (@financial_orbit) was named as one of the ’50 accounts investors should follow in 2017’.

The content on this page does not constitute financial advice and is provided for general information purposes only. Nothing on this page should be regarded as an offer to conduct investment business or to buy/sell any investment.