THE NEXT STOCK MARKET CRASH

THE NEXT STOCK MARKET CRASH

The U.S. had printed too much money during the 2008-2009 financial crisis and while the property market was going through a major crisis due to the sub-prime mortgage scheme, the financial institutions' crisis forced the Fed to bail out a number of them. Then, the Fed has tried to encourage investment and spending by lowering the interest rates by force (historically low short-term policy rates, repeated reassurances that interest rates are going to stay low for some time and quantitative easing). The bubble that emerged ever since in the stock market has been characterized by the investment into the blue chip stocks that could be bought and held forever with confidence. The mutual funds have been presented as the safest and the fastest way to get rich for the common man. As the bubble expands, investment managers use aggressive investment techniques in order to generate huge increases in the value of their mutual funds shares. As mutual-fund asset values goes up, new money pours in. Thus, we have a self-reinforcing process which gives the false illusion of a money-making machine for everyone. But as the value of the assets has reached its intrinsic value, the thin spread between price and value forces the investment managers to take on more and more risks in order to generate adequate returns.

We can say that the next financial crisis will be due to the mutual funds as the decline in prices will inevitably be followed by a drop in the value of their assets. This will be triggered by the expectation that the Fed is about to end its quantitative easing program later this year (expected in October) which in turn should result in a rise in bond yields. Institutional investors  are in search of avoiding risk and will start soon to switch from the overvalued equities to the bonds which seem to be overvalued. The current bet in the market is on the extended period of low yields and are willing to invest for longer terms i.e. 30 years but these long term bonds do not offer adequate protection against any future rise in the interest rates.

Consequently, as the investors will get worried by this decline, they will start to cash in their mutual fund shares which in turn will force the investment managers to sell more assets thus starting a downward spiral. This may result in a severe drop in the stock market (say between 30% - 50% range) within a period of two years. But the blow will hit harder the stock markets of the emerging countries where drops in the 70% - 80% area would not be uncommon.

When the market will hit the bottom, a new area will open and we will see the rebirth of the value investment. Following the bottom out of all the main stock indexes, in all cases the recovery may be a slow process. Although some of these markets will recover faster than the others by returning to the original level within a couple of years, in real terms, this will take longer than expected with the inevitable surge in the inflation coupled with the rise of the interest rates.