The stock market is overpriced and needs to come down to 1200 for the SP to be fairly priced. It doesn’t require a recession for stocks to come down. When the Dutch Tulip bulb bubble broke it was because the price was too high so people simply woke up and started selling.
One possible trigger for a stock crash could be the current rout in the junk bond market. When investors get hungry for yield they may be tempted to trust junk bonds too much. Currently investors have been getting out of junk last week and the price of junk has been going down, which means the yield is going up. This could result in some providers of junk financing from withdrawing from the market, thus cutting off shaky borrowers from much needed funds. The effect of extreme Federal Reserve easing since 2008 and low rates is that more investors were pushed into the junk bond type of assets which ultimately loan money to high risk small businesses, etc. In a credit crunch, shaky borrowers can lose access to credit and simply not have enough funds to operate, causing a business to collapse.
The foreign version of junk bonds are Emerging Markets bonds. The majority of EM borrowers are below investment grade (junk) quality. If U.S. investors get cold feet and suddenly withdraw from EM countries (as happened during the Taper Tantrum of June, 2013) then that could result in loss of funding in EM countries, resulting a recession that spreads to the U.S. These countries have been overstimulated by an excessive amount of easy credit that produced an unsustainable boom in EM countries. Except for China which has a closed system, most EM countries will be hurt by an outflow of foreign capital during the next crisis.
Yellen said that inflation is just “noise”. She may be right because if EM countries had a bogus debt fueled boom and are due for a crash then that will revert the commodities boom into a bust with fire sale prices for commodities. China imported, in two years, the same amount of cement that the U.S. used in almost a century. Surely that can’t be logical, so eventually demand for cement will go down, thus reducing global prices and creating layoffs.
The dollar may go up in value as the Euro and the Yen get devalued and as the Federal Reserve raises interest rates. A rising dollar will make it harder for EM countries to repay loans denominated in dollars, leading to an EM default and global recession.
The year before presidential elections (such as 2015) are the best odds of crash on a four year cycle. The recovery will have been six years old, so it may be time for recession, and it has been a junk fueled recovery but people are getting scared of junk; so if credit markets got scared of junk that could cut off vital funds to shaky debtaholics who would sharply reduce consumption, etc.
The perfect storm could be when the Fed raises rates in 2015 during the third year of the four year presidential cycle, which is the weakest year in the cycle and then the increase in rates damages the Third World EM countries creating a global recession.
Because stocks are very high priced, with a price 59% over fair value, then they will come down even if earnings hold steady. John Hussman wrote today in “A Hint of Advance Warning” “The stock market dropped by half in 1973-74 even while S&P 500 earnings grew by over 50%. The 1987 crash was associated with no loss in earnings. Fundamentals don’t have to change overnight. There is in fact zero correlation between year-over-year changes in earnings and year-over-year changes in the S&P 500.”
The extreme Fed stimulus of QE and zero rate policy have encouraged speculators to buy on margin which may mean they placed a stop-loss order that will be triggered during a Flash Crash. The market has been influenced by excessive Fed stimulus which encouraged a speculative bubble. However the speculators are aware of the short term nature of their low rate funding so they are willing to quickly sell off and close out their positions if the market were to go down, thus exacerbating the problem.
Investors need independent financial advice about the risks of a sudden crash even when the economy is still growing. I wrote an article “Get ready for the end of the bull market”.