I think there’s a growing risk the stock market could crash next year. Here, I want to look at three reasons why this could happen and explain why I’m starting to feel nervous about 2020.
One reason why markets crash is stock valuations become unrealistically high, forming a bubble. At some point, reality intervenes and the bubble pops. Investors start selling stocks as fast as they can. A good example of this was the dot-com crash in 1999, when the market was driven to record levels by barely-profitable tech firms with crazy valuations.
However, I don’t see any reason to worry about stock market valuations at the moment. The FTSE 100 looks quite reasonably priced to me, with a price-to-earnings ratio of 15 and a dividend yield of 4.5%.
Election might trigger sudden shock
Another reason for a market crash is when a sudden shock hits the real economy, triggering panic among investors. The 9/11 attacks in the US were an example of this. The FTSE fell by around 20% following the attacks, but bounced back quickly when it became clear the economic impact of the attacks would be contained.
This isn’t the place for politics, but one possibility is that a Labour election win in December could trigger a similar shock to the UK market. Many investors are wary about Labour promises to nationalise utilities and hand a 10% stake in large companies to employee ownership funds. A strong win for Labour could cause investors to dump shares in companies which might be affected.
Personally, I don’t see the election result as a serious concern for long-term investors. I suspect any impact will be short term and probably smaller than expected. In my view, what we should be worrying about is the risk that the real economy could slow, causing corporate earnings to fall.
Are earnings about to collapse?
I’ve said the stock market looks reasonably valued. That’s true, but it relies on corporate earnings remaining stable or continuing to rise. Unfortunately, I’ve noticed in recent months that earnings expectations for many big companies are falling. In particular, I’ve noticed earnings growth forecast for next year has fallen sharply.
I’m particularly worried about banks, which are generally seen as a play on the economy. I wrote recently about how profits at UK-focused Lloyds Banking Group are now expected to fall in 2020. The same is true of Asia-focused HSBC Holdings.
I’m also concerned that companies are choosing to return more of their earnings to shareholders than they were a few years ago. Using archive data from the Financial Times, I calculate the average dividend payout ratio for FTSE 100 companies has risen from 50% to 68% over the last five years.
This suggests to me that companies are focusing on cost-cutting rather than investing in new growth. I suspect 2020 could be the year when we start to see corporate earnings slow. If I’m right, a stock market slump could follow.
Of course, this wouldn’t be all bad news. If you’re still building your portfolio, then a market crash usually provides opportunities to buy good stocks at bargain prices. But crashes can be a scary experience — which is why I’d suggest focusing on profitable and well-established firms at the moment, rather than speculative stocks.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended HSBC Holdings and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.