Michael Burry, the famous investor from the movie “The Big Short”, invited an SEC visit last week for tweeting his views on how he sees a market crash coming.
Well, the SEC was quick in shutting Burry’s mouth as he had to delete his Twitter soon after, but his tweet’s resonated well with people who are asking, “Will the market crash again in 2021?”
It is a burning question right now because, despite all the catastrophe that is going on in the economy, the stock market is behaving absolutely irrationally.
The stock market landscape in 2020 and 2021 has been very different than what we were normally used to, especially for the boys of wall street.
There seems to be no end to the optimism, especially now that Covid-19 is kind of behind us, people are fed up with being at home, and the economy can’t just wait to open back up, if not already opening up.
But what is backing up this optimism apart from the endless support from the government? And what happens when the support ends?
Our guest today is James McDonald, founder and CEO of Hercules investment, LLC, and he thinks there is a combination of things that could be worrisome for the stock market in 2021.
Today, we’ll be asking him will the market crash again in 2021, and if yes, what could be the driving factors and how to prepare for it? So, let’s go!
Will the Market Crash Again?
James says that the market is in an unprecedented and anomalous state of extreme uncertainty. We have faced a pandemic in a way that our economy has never seen before.
Last year this time, the fear of pandemic was twofold. There were obviously the health implications of it, and then there were the economic implications like widespread job loss and businesses closing down. All these, of course, lead to a market crash that we all witnessed in march.
In response to the unprecedented crisis, the government threw away its playbook for monetary policy, fiscal responsibility, and interest rate management. Which, combined with people receiving paychecks to replace lost income, propelled the market into a place its never been before. The rally that has followed the crash has pushed stocks way higher than they were before the pandemic.
If we keep in mind the fact that stock prices were already overvalued before the pandemic and a correction was due irrespective of a pandemic, then what we’re seeing now is an even more overvalued market.
What adds to the fire is the fact that our economy now is even more unstable, corporate profits are even lower, and unemployment is higher than before. Still, the stock market is making all-time highs.
To any rational investor, it is very difficult to grasp that the market is more valuable now than it was ever before.
But Why Is The Market Going Up?
Let’s understand this with the help of an analogy. In any auction, the enthusiasm of the bidders is what drives the price higher. The stock market is also an auction where the enthusiasm of the bidders drives the price.
There was so much money made in the recovery from last march that the sentiment of the bidders in the market, their thirst and desire for gains, is so high that they keep on pouring money into the market, which drives it higher and higher.
So even when the market kind of consolidates, we have rotations. First, all the usual suspects like TSLA, AMZN, GOOG, NFLX climb up. When they go for a correction, the money starts flowing towards the small-cap, and they start rallying.
The cycle keeps going on. Whenever one thing starts slowing down, the flow of money finds a new home.
When the consolidation starts growing in different sectors of the market, that marks the abatement of the enthusiasm. Generally, there’s some negative news that hits the market, which turns the enthusiasm into pessimism. If this news is really negative, then pessimism grows in the market, which sometimes leads to a significant sell-off.
What Could Cause the Market Crash?
One of James’s favorite expressions in the market is- “There are three phases in the market- either you’re headed into a storm, you’re in a storm, or you just got out of a storm.”
James believes that we’re definitely headed to a storm, but that storm is controlled right now. We have guard rails from the federal government where they can simply add more stimulus, increase the paychecks, or provide reliefs in the form of tax cuts.
These guard rails have kind of created a sense of complacency, especially among the retail investors. Platforms like Robinhood have reduced stock investing to a game where people are ready to take uncalculated risks to push stock prices around.
If you look at the overall picture, you’ll realize that everything going on right now, whether it’s the unlimited government support or growing complacency among investors, is leading to a storm.
There is a gap that has been growing between real corporate profits, GDP, and stock prices. The gap is now 50% wider than its ever been. There has to be a reconciliation because in all previous cases this gap has widened, there has been a major market crash.
However, there’s this paradox in the market that the worst things get, the higher stocks go. It happens because as risk becomes substantial, the federal government offers more protection.
We saw this exact phenomenon from October to December last year, when the graph of infections went up, stock prices went up as well.
Now, it’s important to understand that at some point, things normalize. And when they do normalize, we find ourselves in an extreme state of stock market valuations, which are not justified by any means. In simple terms, normalcy does require the stock market to come down precipitously.
But Aren’t Things Different This Time Around?
The stock market landscape has changed a lot recently. It’s not only about the big boys of wall street now, but apps like Robinhood have enabled people who normally don’t invest to start investing. A lot of gurus have popped up online teaching people that you should buy when the market drops.
Now, almost everybody in the market has this vision that they have to buy when the market drops. In such a scenario, how can you define normalcy anymore?
Well, James says that it depends on the time frame that you’re studying. From March 2009 to last year this time, the bull market was unprecedented. We saw 12 years of uninterrupted growth.
We’ve never seen a bull market like that, where stock prices grow for that long of a time and go that high. Although Covid was unexpected, the interruption in growth last year was pretty expected.
But the crash that happened was followed by a recovery that was faster than at any point in history. Any recession we’ve had lasted for at least a couple of years, if not more.
If we agree that we were in recession last year, at least according to stock prices, then our rescission lasted only about 45 days. So how can that be that an entire economy recovers in less time than it takes to lose 10 pounds?
Talking about the retail trader boost, we’ve seen this before. We’ve seen a similar surge with the introduction of online brokerages and introduction of easy, low-cost discount brokers.
The result of this type of boost in market participants brings in a ton of money, and along with that, a ton of inexperience in the market. The inexperience and affluence of cash oftentimes lead to euphoria, and then we see consequences like the dot-com crash.
When Can it Happen and What to do?
When the market will crash is a harder question than will the market crash again. The market can remain irrational longer than you can stay solvent. So it’s always better to not try and predict the next move.
The best thing to do right now is to continue using earnings, GDP, and personal spending data as a guide to keep a check on the temperature of the market.
Also, keep an eye on the Covid-related numbers and how the vaccine rollout is going because that will also play an important role in determining the mood of the market.