Another Market Crash? Here's When It Could Happen
Updated: Jul 14, 2020
Although timing the market is a near-impossible task, research can paint a fairly accurate picture regarding if we can expect another market crash, and more importantly, when it could occur.
In a previous article, The Dividend Payout drew upon several indicators that confirmed a second market crash is likely to happen: investors have been saving truckloads of cash, probability of defaults are high, and stocks are overvalued as a whole. In other words, we strived to answer if there would be another crash, and arrived at a fairly concrete yes.
The next step would be to estimate a timeframe for the same, which is why we’ve compiled a list of 3 events that could answer the when part of this paradigm. Aside from the obvious one (if a second wave of COVID-19 infections spread), here are the most logical periods that could involve another market crash.
1. Second-Quarter Earnings Release (Mid July)
Worldwide lockdowns would’ve hindered businesses – retail, restaurants, airlines, and the like – from earning usual or even adequate revenue. In fact, Deloitte estimates that over 85% of small-to-medium enterprises (SMEs) will run out of cash by the end of June, with over 25% of restaurants not even returning at all: and that's the bare minimum. When we factor in the complexity of reopenings, social safety and a lack of cash, the outlook becomes even more obscure.
In other words, investors will be exposed to massive corporate losses in Q2 (a), but will also be conflicted from not fully knowing what to expect (b).
The path for a crash comes particularly from part b), because that uncertainty isn't going to be pretty.
Figure 1: Revised forecast for Q2 earnings shows heavy drop
Although earnings are forecasted to drop to almost half (-43.5%) of what they were in Q2 last year, this figure becomes especially significant when we consider how unconvincingly these forecasts were made.
Companies have suspended providing their own revenue/profit/cash expectations, as they've openly - and quite frankly - said that they have "no visibility" in such an unprecedented market. In other words, analysts have to use new information and new developments (regarding reopenings, virus cases and medicine) to predict earnings instead of the numbers usually provided by businesses.
When new information and new developments occur every day in this market, how do we accurately predict corporate profits?
The drastic change in FactSet's forecast (from -13.5% to -43.5% within two months) suggests we probably don’t.
Uncertainty is ubiquitous here, and this is why we could see either:
a) Investors pulling out before earnings release, due to the uncertainty around estimate accuracy; or
b) Investors rapidly selling off because actual results are far worse than estimates (i.e. uncertainty caused predictions to be grossly incorrect).
2. When the money stops moving
The current market rise (now up 47% since March 23rd) is largely linked to the powerful moves made by central banks, and rightly so.
Figure 2: Spike in central bank spending since March 2020
The Federal Reserve has especially provided levels of finance that are completely unprecedented: causing investors to “price in” the idea that central banks will support assets throughout this crisis, no matter what. As mentioned in our previous article, these measures act like an insurance policy to buying stocks: if we know prices will be protected, why not go all in?
Perhaps because a Fed “backstop” may not last as long as we think…
Let’s not look at what the Fed is doing now but what they’ll be doing in 3 months, 6 months, 1 year? Because that’s what investors are betting on at the moment” – Tim Seymour on Fast Money, CNBC
With the central bank set to lose over $400 billion on defaults (when companies fail to pay back debt), can we confidently say that the Fed will still uphold their financial support 6-12 months down the line? Difficult to say.
They choose where the money moves: but if they continue underwriting so much debt, we can expect the following consequences from market mechanisms. Either:
a) The Fed may have to take their foot off the gas (i.e. if too many defaults occur, they'll reduce financial support); or
b) Diminishing marginal returns will come into play (i.e. the market will stop reacting so positively to central bank moves, because each new action increases risk from the investor's perspective).
In other words, when the "Fed effect" submerges and investors realize the stock market isn't as protected as they presumed, market crash 2.0 is a logical consequence.
3. 133 days
Even though the old adage says past performance is not an indicator of future results, looking at historical patterns still informs us of a) how often rapid market rises occur in recessions (known as bear-market rallies) and b) how long exactly they can last.
Bloomberg estimates that such false market rises last around 133 days, with the visual depictions below mostly supporting this claim.
Figure 3: Two previous bear-market rallies showing length of about 3-4 months (orange lines)
Understanding the history of bear-market rallies may not give us an accurate answer as to when this stock market will reverse, but they can certainly provide a timeframe to prepare.
Markets are now well-ahead of economic reality, and investors should prepare for a correction (crash) on the cards over the coming months - Rupert Thompson, CIO Kingswood Group
Fund managers have begun protecting their investments: building up on cash, focusing on blue-chip stocks and nibbling on Gold in order to hedge their bets. Although a wide array of defensive strategies are being deployed by these professionals, us retail investors need to focus on two key themes over the next few weeks: reduce exposure and build composure.
In other words, keep cash aside and resist the urge to play it back in the markets the next day, because these figures show that a crash - when it happens - is here to stay.
With mid-July (Q2 earnings season) and the first week of August (133 days after the rally began) kept as our timeframe, investors should consider turning risk-off before market crash 2.0 materializes.