When worrying about the next stock market crash, I remember this general principle: “market timing is for suckers”. Market timing involves switching money between different asset classes, based on expectations of future price movements. It involves predicting the future, which is notoriously tough. Despite this difficulty, I’ve pulled out of UK shares several times. On every occasion, these decisions were driven by watching euphoric investors taking excessively high risks.
My wife and I switched from UK shares to US stocks soon after the 2016 Brexit vote. That proved to be a great call. In late 2019, content with our gains and worried about frothy US stocks, we moved 50% into cash. Within months, we were back to 100% stocks again — and fully invested within days of March 2020’s market low. These three attempts at market timing all paid off handsomely, producing life-changing gains. Of course, market timing can also go terribly wrong, as many investors have discovered to their cost. Even so, I’m worrying about the next stock market crash. Here are two danger signs I’m tracking.
1) Excessive SPACulation
Special purpose acquisition companies (SPACs) are ‘blank cheque’ firms that raise money by listing on stock exchanges. The idea is that SPACs then merge with private companies, thus avoiding the comprehensive disclosure and hefty costs associated with initial public offerings (IPOs). Enthusiasm for SPACs seemed unbounded in 2020/21, but many have been predictably disastrous for investors. According to the Financial Times (FT), of 41 SPACs completing $1bn+ transactions since 2020, only three are within 5% of their peak stock prices. Eighteen have more than halved in value, while several have collapsed by 80% or more. The average decline from peak prices is 39%. One (in)famous SPAC, Nikola — a developer of electric trucks — has seen its stock collapse from a high of nearly $94 to $11.57 today (down 87.7%). With excessive market exuberance and overvaluation often preceding stock market crashes, I’m wary of more SPAC attacks.
2) Lavish leverage often precedes stock market crashes
Leverage involves using borrowed money or financial derivatives to magnify gains (or losses) from trades. Leverage is an investor’s best friend when prices are rising, but their worst enemy when they fall. In the FT last week, Gillian Tett warned that margin debt (where investors borrow from their brokers) is at a record high. On Wall Street, margin debt soared to $822bn at end-March. That’s more than double the $400bn peak it hit in 2007, just before the global financial crisis of 2007/09. Furthermore, at the 2000 and 2007 market peaks, margin debt reached 3% of US gross domestic product (GDP). Today, it’s almost 4%. Again, this makes me worry about the damage to come in the next stock market crash.
Am I selling now before the next meltdown?
No. I think it would be a mistake to bail out now, because the world economy is poised to boom post-Covid-19. If growth surges strongly in a sustained economic boom, then this should lift company earnings and thus support lofty prices. My strategy to counter the next stock market crash is simple. I’m reducing my exposure to expensive stocks and using these proceeds to buy cheap shares. Right now, I think there is huge value to be found in the FTSE 100 index, especially among its heavyweight members. Thus, my strategy for 2021/22 is to pack my portfolio with cheap UK shares, backed by strong earnings and chunky cash dividends!
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Cliffdarcy has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.