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The equity markets have made a remarkable recovery in the last year. The coronavirus decimated global economies as governments announced lockdowns and shut their borders. Oil prices experienced a downward spiral due to tepid demand while several retail houses filed for bankruptcies.
Airline stocks booked massive losses as international and domestic travel came to a standstill. The S&P 500 ventured into bear market territory in just over a month and declined by 35%. However, since then, the spectacular snapback rally witnessed has confounded investors as well as analysts.
The rally was primarily driven by tech stocks that gained momentum due to the shift to remote work as well as the transition towards e-commerce. The S&P 500 Index touched a multi-year low at on March 23 last year but ended 2020 with a year-to-date gain of 16%.
However, there is a good chance that the stock markets will crash again in 2021 and let’s take a look at few reasons that will drive the decline.
A high Shiller price-to-earnings ratio
Several stocks are trading at an expensive valuation. The most common way to value the equity markets is by looking at the price to earnings ratio that stands at 35x right now, compared to its historical average of 17x.
Historically, whenever the equity markets touched a PE ratio of 35, it has been followed by a market correction or even a market crash. Two of these instances were during the Great Depression and the dot-com bubble.
So, even if the PE ratio manages to move below 30x. it would mean the markets would fall by at least 20%.
Government programs is fueling the rally
In the last year, several federal governments stepped in and paid billions of dollars to individuals and businesses in order to help them amid the pandemic. The Federal Reserve also lowered interest rates to provide easy access to capital and boost consumer spending and investments.
While interest rates are likely to remain near record lows, it will be impossible for governments to keep paying residents a monthly benefit via stimulus programs. In case unemployment rates continue to be high, there is a good chance for another financial crisis to impact the banking industry, similar to the one seen back in 2008, as delinquency rates will move northwards.
The final takeaway
While it is impossible to time the broader market, investors should look to hold a portfolio of quality blue-chip stocks that are ideally recession-proof and have a steady stream of cash flows with rising profit margins.
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