News flash: Stocks can go down, too.
Since the March 2020 bear market bottom, the tech-heavy Nasdaq Composite (NASDAQINDEX:^IXIC) has been virtually unstoppable. The growth-oriented index more than doubled in value in less than 11 months. But since peaking on Feb. 12, 2021, the Nasdaq has run into some trouble.
This past Monday, March 8, the closely watched index tumbled to a closing value of 12,609. That marked its lowest close since Dec. 15, and officially put the Nasdaq Composite in correction territory with a decline of 10.5%.
But what if this were just the beginning of a larger move lower, or perhaps even a crash? At the moment, there are three catalysts that suggest the Nasdaq Composite could break down from a run-of-the-mill correction into a full-fledged crash.
1. Valuation
Although rapidly rising Treasury yields have recently been the biggest cause for concern on Wall Street, valuations might be an even more worrisome.
According to enterprise data provider Siblis Research, the Nasdaq 100 — an index of the 100 largest non-financial companies listed on the Nasdaq exchange — ended 2020 with a trailing 12-month price-to-earnings (P/E) ratio of 39.5 and a cyclically adjusted price-to-earnings (CAPE) ratio of 55.3. The CAPE ratio takes into account inflation-adjusted earnings for the previous 10 years. For some context here, the Nasdaq 100’s trailing P/E ratio on Dec. 31, 2020 was practically double where it ended 2018 (20.3), and the CAPE ratio is well above historic norms.
And it’s not just the Nasdaq 100, either. The CAPE ratio for the S&P 500 (SNPINDEX:^GSPC) stood at 35.3, as of Wednesday, March 10. That’s more than double its average reading of 16.79 over the past 150 years. There have only been five instances where the S&P 500’s CAPE ratio has surpassed and sustained 30. In each of the previous four instances, the benchmark index lost between 20% and 89% of its value.
Don’t worry, the 89% loss associated with the Great Depression is highly unlikely to happen again. But a bear market has previously always been in the cards when valuations get pushed to the extent we’re seeing now.
2. Coronavirus variants & vaccine uptake
In many respects, the news has been mostly positive on the coronavirus disease 2019 (COVID-19) front. Following the Food and Drug Administration’s emergency-use approval of Johnson & Johnson‘s COVID-19 vaccine, there are now three vaccine options for Americans. The U.S. has also administered at least one dose to more than 19% of the U.S. population.
And yet, the pace to vaccinate may not prove quick enough. The issue being that the SARS-CoV-2 virus that causes COVID-19 has mutated multiple times since the initial virus was discovered. These mutations threaten to diminish the efficacy of the approved vaccines. Even if herd immunity were to be reached within the U.S., variants could develop outside the U.S. and be brought here unknowingly by travelers.
Further, it’s unclear if a large enough percentage of the U.S. adult population will choose to get vaccinated. A February survey from Pew Research Center finds that approximately 30% of respondents definitely or probably won’t get the vaccine. Though this means 70% eventually will get the vaccine, some researchers have suggested a higher vaccination uptake percentage would be needed to reach herd immunity.
Long story short, with select states reopening or relaxing restrictions and the pandemic not yet in the rearview mirror, there’s the clear possibility of setbacks arising.
3. A heightened use of leverage among retail investors
A third reason to be concerned about the Nasdaq, and growth stocks in general, is the leverage that retail investors have been using.
According to a Harris Poll from September 2020, 23% of the retail investors surveyed had purchased options, another 10% had purchased stocks on margin, and a further 10% had both purchased options and bought stocks on margin. Effectively, 43% of all retail investors were using some form of leverage or speculation in an effort to try to time the market.
For nearly 11 months, things went very right for these retail investors. But over the past month, leverage has been a curse. If equities begin moving in the wrong direction, it could lead to margin calls — i.e., instances where brokerages request additional funds from investors to maintain a certain level of liquidity, relative to what they’ve borrowed. Historically, most stock market crashes are exacerbated by the combination of emotional short-term trading and margin calls.
In other words, just as retail investors have excited Wall Street with the Reddit frenzy, they could be its short-term undoing if a wave of margin calls were to strike.
The best thing about crashes
Now, keep in mind that just because the catalysts for a crash exist, it doesn’t mean one is imminent. An argument could have been made throughout the 2010s that a bear market was brewing. Ultimately, we made it through the entire decade with nothing more than a few steep corrections (losses of up to 19.9%) in the S&P 500.
However, should a Nasdaq Composite crash arise, it would actually be a blessing in disguise. Crashes are historically short-lived, emotion-driven, and always an opportunity for long-term investors to put their money to work in great companies. Eventually, all of the major U.S. indexes recoup their losses from crashes and corrections.
For now, we watch patiently to see how growth stocks react to their first real challenge since March 2020. But it wouldn’t hurt to have some cash at the ready in case one or more of the aforementioned catalysts comes to fruition and the Nasdaq plunges.
