Have you heard something like “the stock market is going to crash in 2022”? Are you wondering if it’s time to sell your stocks? We’re seeing a lot more predictions of an impending stock market crash, including one by the “The Big Short” investor Michael Burry. Though it’s impossible to fully predict the future, we can still take a closer look at all the discussion going on. In this blog, I’m going to share 3 reasons why some experts believe the stock market is going to tank in 2022 and 3 counter arguments on why there may not be a stock market crash at all. Lastly, I will share my opinion on whether I think the stock market will crash in 2022.
What is a market crash?
A market crash is when there is a significant and rapid decline in the stock market. Market crashes have occurred on average every 5.4 years since 1945. Some famous stock market crashes were in 1929, 1987, 1997, 2000, 2008, 2015, and 2018. We also experienced a downturn in 2020.
What is the P/E ratio?
The price-to-earnings (P/E) ratio is a way to value a company by comparing the price of its stock to its earnings. A high/low P/E ratio can indicate that the stock price is too high/low relative to earnings. This could mean that it is an overvalued/undervalued stock market.
Top 3 reasons why the stock market may crash in 2022:
1) Inflation is skyrocketing.
Inflation had been hovering below 2% for the longest time and then it rose to over 6% in October & November last year. Inflation is hitting the highest it’s been since June 1982. I don’t need to tell you that inflation is skyrocketing. You are all experiencing it. Gas prices are higher, grocery bills are higher, new and used car prices are up and housing prices continue to climb.
2) Interest rates are expected to rise in 2022.
The Federal Reserve is finally realizing that inflation may not go away unless they do something about it. They will start to raise interest rates in 2022, to combat high inflation. The word on the street is that they’re going to do three interest rate hikes, possibly starting as early as March. High interest rates are typically not good for fast-growing technology stocks.
3) The US Stock market seems very expensive.
The stock market valuation is at a 20-year high. What does that mean? We’re going to geek out a little bit and look at one key metric that stock market gurus often look at.
- Shiller P/E ratio is at 38. The Shiller P/E ratio averages earnings of the S&P 500 over the past 10 years and adjusts for inflation. This minimizes the effects of business earnings cycles and market fluctuations. The numbers range from 5 to 40.If the P/E ratio is 5 or 10, then the stock market is really cheap. The average is around 16. At the moment it is sitting at 38 which is more than twice its average. Last time we saw that kind of valuation was right before the dot.com bust or 2000 stock market crash.
- The “Buffet Indicator”, which was popularized by Warren Buffett, compares the value of the US total stock market as a percentage of national gross domestic product (GDP). It is currently 200%.
- “Ideal” US total stock market is around 90% of GDP (some companies are private), where many would consider it fairly valued.
- Cheap to buy when at 60% or 70%, as it was in late 2008/early 2009.
- Buffett also mentioned that “if the ratio approaches 200%… you are playing with fire.” Right now it’s at 200% of GDP which suggests that the stock market is strongly overvalued.
- Jeremy Grantham, a famous investor who correctly predicted the 2000 tech bubble and 2007 housing bubble, has labeled the stock market as an “epic bubble, ” featuring “extreme overvaluation, explosive price increases, and hysterically speculative investor behavior.”
So should I sell all of my stocks now?
If a market crash is on the horizon for 2022, you may be tempted to pull your money out of the market to avoid any losses. However, this may not be a wise decision. Perhaps you shouldn’t sell all of your stock holdings based on emotional decisions or rash predictions. Next we are going to discuss 3 counter arguments on why the stock market will not crash in 2022.
3 counter arguments that the stock market will not crash in 2022
1) Yes, high inflation is bad but, in theory, stock market returns are neutral to inflation.
Companies can pass on higher costs to consumers. Stocks can be a decent hedge against inflation. For example, during the high inflationary period of 1966 to 1982 (due to the oil crisis), the S&P 500 returned 6.8% annualized, matching the rate of inflation.
2) Higher interest rates do not necessarily lead to stock market crashes.
On average, the S&P 500 has decreased by 1.8% in the three months after the first interest hike. However, it has then gained 7.7% after 12 months. If we look at more robust data from U.S., Japan and European stocks, there seems to be no relationship between interest rates and stock price multiples.
3) “Stock market is expensive.”
Let’s examine this quote more closely.
- Expensive due to high price to earnings ratios? Let’s take Amazon as an example. The Amazon P/E ratio is 62. This is very expensive and much higher than S&P 500’s P/E ratio of 38. However, multiples are a little less meaningful for Amazon and other companies who are doing ongoing heavy investment and rapid scaling that depresses financial performance. Morningstar estimates that Amazon is trading at a 30% discount, as of January 21, 2022.
- If you look at the top 10 holdings of the S&P 500 right now, using Morningstar’s analysis, only 3 of them are overpriced.
- If you want to look at a hard metric, we can look at the Fed Model. The Fed model is a market timing tool that compares the stock market’s earnings yield, with the yield on long-term government bonds. According to this model, stocks are considered overvalued when the Treasury yield exceeds the earnings yield. As you can see from the data below, right now, it’s not. This means that based on this metric, the US stock market is not very expensive.
- US stock market earnings yield: 2.58%
- 10-year U.S. Treasury yield: 1.78%
- When there was the Tech bubble (also known as the dot-com bubble), investors were buying lots of companies with no revenue and with no earnings. That is not what is happening right now, except for meme stocks, crypto, and SPACs (special purpose acquisition company).
A certified financial advisor’s take on whether the stock market will crash in 2022.
It’s good practice to always exercise a cautionary ear towards people who predict stock market crashes. Market timing doesn’t work and it can backfire. If you are always chasing the market then you will be constantly stressed. Depending on your situation, it may work to your advantage to ride out the fluctuations. As a whole, the stock market has historically recovered from its losses.
Will the stock market crash in 2022?
While no-one can predict the future, we have given you some information to make your own prediction about whether the stock market will crash in 2022. If it does crash, remember to not make any rash decisions. If you’re still worried about a stock market crash and are looking for safe but potentially high return investment, then check out our recent blog about I Savings Bonds. If you want to elevate your finances in 2022, schedule a complimentary discovery call with one of our certified financial advisors today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.