What’s new: stocks may also fall.
Since March 2020, the bear market, the high-tech sector Nasdaq Compound (NASDAQINDEX: ^ IXIC) it has been virtually unstoppable. The growth-oriented index more than doubled in less than 11 months. But since the peak on February 12, 2021, the Nasdaq has had some problems.
As of last Monday, March 8, the closely observed index fell to a close of 12,609. This marked its lowest close since December 15, and officially placed the Nasdaq Composite in correction territory, down 10.5%.
But what if this was just the beginning of a bigger downward movement, or maybe even a fall? At the moment, there are three catalysts that suggest that the Nasdaq Composite could break from a common fix in a complete crash.
Image source: Getty Images.
1. Evaluation
While the rapid increase in Treasury yields has recently been the biggest cause for concern on Wall Street, valuations can be even more worrying.
According to corporate data provider Siblis Research, the Nasdaq 100 – an index of the 100 largest non-financial companies listed in the Nasdaq exchange rate – ended 2020 with a 12-month price / earnings ratio (P / E) of 39.5 and a cyclically adjusted price / earnings ratio (CAPE) of 55.3. The CAPE index takes into account the inflation-adjusted earnings of the previous 10 years. For some context here, the final P / E ratio of the Nasdaq 100 on December 31, 2020 was almost double where it ended 2018 (20.3), and the CAPE index is well above historical norms.
And it’s not just the Nasdaq 100. The CAPE ratio for the S&P 500 (SNPINDEX: ^ GSPC) stood at 35.3 on Wednesday, March 10. This is more than double its average reading of 16.79 over the past 150 years. There were only five cases in which the S&P 500 CAPE index exceeded and remained at 30. In each of the previous four cases, the reference index lost between 20% and 89% of its value.
Don’t worry, the 89% loss associated with the Great Depression is very unlikely to happen again. But a bear market has always been on the cards when valuations are pushed to the extent we see now.
Image source: Getty Images.
2. Coronavirus variants and vaccine absorption
In many respects, the news was mostly positive in front of coronavirus 2019 (COVID-19). Following the Food and Drug Administration’s emergency use approval for Johnson & Johnsonof the COVID-19 vaccine, there are now three vaccine options for Americans. The United States has also administered at least one dose to more than 19% of the US population.
However, the rate of vaccination may not be fast enough. The problem is that the SARS-CoV-2 virus that causes COVID-19 has mutated several times since the initial virus was discovered. These mutations threaten to diminish the effectiveness of approved vaccines. Even if collective immunity were to be achieved within the United States, variants could develop outside the United States and be brought here unknowingly by travelers.
In addition, it is unclear whether a large enough percentage of the US adult population will choose to be vaccinated. A February survey by the Pew Research Center found that approximately 30% of respondents definitely or probably will not receive the vaccine. Although this means that 70% will eventually receive the vaccine, some researchers have suggested that a higher percentage of vaccination would be needed to achieve collective immunity.
To make a long story short, with some states reopening or relaxing restrictions and the pandemic not yet reflected in the rearview mirror, there is a clear possibility of setbacks.
Image source: Getty Images.
3. An intensified use of leverage among retail investors
A third reason for concern about Nasdaq and growth stocks in general is the influence that retail investors have been using.
According to a September 2020 Harris survey, 23% of retail investors surveyed bought options, another 10% bought shares at the margin and another 10% bought options and bought shares at the margin. Indeed, 43% of all retail investors were using some form of leverage or speculation in an effort to try to time the market.
For almost 11 months, things have gone very well for these retail investors. But last month, leverage was a curse. If stocks start to move in the wrong direction, this can lead to margin calls – that is, cases where brokers request additional funds from investors to maintain a certain level of liquidity in relation to what they have borrowed. Historically, most stock market crashes have been exacerbated by the combination of short-term emotional trades and margin calls.
In other words, just as retail investors excited Wall Street about the Reddit frenzy, they could be your short-term downfall if a wave of margin calls broke out.
Image source: Getty Images.
The best thing about crashes
Now, keep in mind that just because catalysts exist for a crash, it doesn’t mean that one is imminent. An argument could have been made over the course of the 2010s that a bear market was forming. Ultimately, we went through the entire decade with nothing more than a few sharp corrections (losses of up to 19.9%) on the S&P 500.
However, if a Nasdaq Composite crash occurs, it would really be a blessing in disguise. Crashes are historically short, motivated by emotions and always an opportunity for long-term investors to put their money to work for large companies. Finally, all major US indices recover their losses from declines and corrections.
For now, we have watched patiently to see how growth stocks react to their first real challenge since March 2020. But it wouldn’t hurt to have some money on hand in case one or more of the catalysts mentioned above materialize and Nasdaq plummets.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even our own – helps all of us to think critically about investing and making decisions that help us become smarter, happier and wealthier.