According to every major indicator, the stock market is seriously overvalued. And the stock market bubble is getting bigger. Unfortunately, it never ends well.
Over the last 120 years, we’ve never seen a stock market bubble deflate slowly or get resolved because the stock market has moved sideways. Stock market bubbles pop. What makes a bubble pop? Historically, it’s been rising inflation and interest rates.
Does the Stock Market Bubble Have to Burst?
The old investing adage of “sell in May and go away” didn’t quite go as planned in 2021. When investors sell, the stock market tends to take a breather. That didn’t happen. Instead, the S&P 500 inched up 0.2%.
Despite the move sideways, the broader stock market is still wildly overvalued and in stock market bubble territory. While it’s impossible to predict when the bubble will burst, a stock market crash is a 100% eventuality. Stocks move in cycles, and this time is no different.
What we do know, though, is that rising inflation and interest rates tend to force stock market bubbles to pop sooner rather than later.
Case in point, the October 19, 1987 stock market crash was fuelled by an overvalued bull market, investor panic, and a computer program that sold equity futures when prices fell. As stock market losses accelerated, investors panicked and sold, which led to more selling.
“Black Monday,” as it has been famously called, saw the Dow Jones Industrial Average plunge 22% and the S&P 500 tumbled 20%. It was the single greatest one-day loss on Wall Street. And it brough the five-year-old bull market to an end.
While economists and investors may argue over what triggered Black Monday, what cannot be ignored is that interest rates were on the rise during this period. Slowing U.S. economic growth, a growing trade deficit, and decline in the U.S. dollar led to concerns about inflation and the need for higher interest rates.
Between the start of 1987 and the end of September, the federal funds rate increased from six percent 7.4% by the end of September.
Fast forward to the high-flying dot-com era of the late 1990s. Eager investors afraid to missing out on new fangled Internet companies sent valuations of floundering tech stock through the roof. From the end of 1998 to August 2000, the federal funds rate rose from 4.27% to 6.5%.
By the time the dot-come bubble had burst in late 2002, the Nasdaq had crumpled 78% from its peak.
The 2008-2009 Great Recession and collapse of the U.S. housing industry happened at a time when interest rates were on the rise. From 2004 to 2007, the federal funds rate jumped from approximately one percent to 5.5%.
Where does that leave us in 2021? Stock market valuations are in nosebleed territory. Interest rates are still near record lows, but inflation is ramping up, and the Federal Reserve will need to step in and start raising interest rates. It’s already happening on Wall Street, with the yield on 10-Year Treasury notes soaring from 0.6% to 1.6% in just a few months. And we already saw what that did to the stock market back in February and March.
Panic and fear fuelled by rising interest rates and inflation could send investors running for the exits. If history is any indicator, a stock market crash of 40% to 60% would not be out of the question.
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