Newsflash: Stocks could also drop.
Since March 2020’s lowest market, the technologically heavy Nasdaq Compound (NASDAQINDEX: ^ IXIC) was virtually unstoppable. The growth-oriented index has more than doubled in less than 11 months. But since the peak on February 12, 2021, the Nasdaq has been experiencing problems.
This past Monday, March 8, the well-tracked index dropped to a closing value of 12,609. It was the lowest end since December 15, and officially put the Nasdaq Composite in the correction area with a 10.5% drop.
But what if it was just the beginning of a bigger move, or maybe even an accident? Currently, there are three catalysts that suggest that the Nasdaq Composite could break down from a running fix to a full-blown crash.
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1. Valuation
Although rapidly rising treasury yields have recently been the biggest cause for concern in Wall Street, valuations may be even more worrying.
According to the provider of enterprise data, Siblis Research, the Nasdaq 100 – an index of the 100 largest non-financial corporations listed on the Nasdaq exchange – ended 2020 with a 12-month overdue price-to-earnings ratio (P / E) of 39.5 and a cycle-adjusted price-to-earnings ratio (CAPE) of 55.3. The CAPE ratio takes into account inflation-adjusted earnings for the previous ten years. For a certain context here, the Nasdaq 100’s overdue P / E ratio on 31 December 2020 was virtually double where it ended 2018 (20.3), and the CAPE ratio is much higher than historical norms.
And it’s not just the Nasdaq 100 either. The CAPE relationship for the S&P 500 (SNPINDEX: ^ GSPC) stood at 35.3 on Wednesday, March 10th. This is more than double its average reading of 16.79 over the past 150 years. There have been only five cases where the CAPE ratio of S&P 500 exceeded and 30 persisted. In each of the previous four cases, the benchmark index lost between 20% and 89% of its value.
Don’t worry, the 89% loss associated with the Great Depression is unlikely to happen again. But a bear market used to always be in the charts when valuations are printed to the extent we see now.
Image Source: Getty Images.
2. Coronavirus variants and vaccine uptake
In many ways, the news was mostly positive about the coronavirus disease 2019 (COVID-19). Following the approval of the Food and Drug Administration’s emergency use of Johnson & Johnson‘s COVID-19 vaccine, there are now three vaccination options for Americans. The US also administered at least one dose to more than 19% of the US population.
And yet 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 reduce the effectiveness of the approved vaccines. Even if herd immunity is achieved within the US, variants can be developed outside the US and unknowingly brought here by travelers.
Furthermore, it is unclear whether a large enough percentage of the American adult population will choose to be vaccinated. According to a February poll by the Pew Research Center, about 30% of respondents definitely or probably do not find the vaccine. Although this means that 70% will eventually get the vaccine, some researchers have suggested that a higher percentage of uptake is needed to achieve herd immunity.
Long story short, with select states reopening or easing restrictions and the pandemic not yet in the rearview mirror, there is the clear possibility that setbacks could occur.
Image Source: Getty Images.
3. Increased use of leveraged financing among retail investors
A third reason to be concerned about the Nasdaq, and growth stocks in general, is the leveraged financing used by retail investors.
According to a Harris Poll of September 2020, 23% of retail investors surveyed bought options, another 10% bought shares on margin, and a further 10% bought both options and shares on margin. Effectively, 43% of all retail investors use some form of leverage or speculation in an attempt to time market.
For almost 11 months, things have been going very well for these small investors. But over the past month, leverage has been a curse. If stocks start moving in the wrong direction, it can lead to margin calls – for example, cases where brokers ask additional funds from investors to maintain a certain level of liquidity, relative to what they have borrowed. Historically, most stock market crashes are exacerbated by the combination of emotional short-term trading and margin calls.
In other words, just as small investors excited Wall Street with the Reddit frenzy, it could be undone in the short term if a wave of margin calls were to strike.
Image Source: Getty Images.
The best thing about accidents
Now remember that just because the catalysts for an accident exist does not mean someone is on hand. An argument could be made over the course of the 2010s that a bear market was brewing. Eventually, we made it through the entire decade with only a few steep corrections (losses of up to 19.9%) in the S&P 500.
However, should a Nasdaq Composite crash occur, it would be a blessing in disguise. Breakdowns are historically short-lived, emotion-driven and are always an opportunity for long-term investors to make their money work in big companies. Eventually, all major U.S. indices recovered their losses due to collapses and corrections.
For now, we are patiently watching to see how growth stocks respond to their first real challenge since March 2020. But it will not hurt to have cash ready if one or more of the above catalysts emerges and the Nasdaq collapses. .
This article represents the opinion of the author, who may not be in agreement with the ‘official’ recommendation position of a Motley Fool premium advisory service. We are furry! Questioning an investment thesis – even one of our own – helps us all to think critically about investments and to make decisions that help us become smarter, happier and richer.