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The signs stocks could be heading for a fresh crash

The dizzying ascent of global stocks has unnerved analysts in recent months, as lofty valuations and the prospect of interest rate hikes threaten to spark a major sell-off.

The MSCI All-Country World Index, a gauge of global stocks, set a new peak last month.

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The Dow Jones hit fresh highs on Friday, while London's benchmark FTSE 100 and the German DAX hit all-time highs in June.

Even disappointing macroeconomic data fails to deter the relentless drive higher in stock markets, as investors continue to pile into stocks with overstretched valuations.

Since the immediate aftermath of the Brexit vote, the FTSE 100 has rallied 23 per cent, rising more than 3 per cent so far this year, while the Dow Jones has gained 18 per cent since Donald Trump's US election win. Since January, the benchmark US index has jumped by more than 9 per cent.

While there is no specific threshold for stock market crashes, they are typically defined as a fall of more than 10 per cent in a stock index over the course of a day or two.

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The speed of the decline is what differentiates a crash from a stock market correction. While a crash occurs when markets experience a sudden double-digit drop in a couple of days, a correction occurs when prices fall by 10 per cent or more from the index's 52-week high.

What causes a stock market crash?

Ask experts what causes a stock market to plunge and you'll get a dozen different answers. A deluge of academic research also fails to deliver a conclusive answer. Taking that into account, here are some of the contributing factors:

Market psychology

Conventional financial theory suggests market players behave rationally, failing to account for investor sentiment, which can drive stock prices higher or lower.

Greed, fear and expectations all contribute to investor sentiment. Periods of strong optimism among investors can artificially inflate stock prices, which creates a "bubble" and subsequently has the potential to burst.

Widespread panic

A stock market crash is exacerbated by panic. Typically, investors who think the market is about to falter begin to dump stocks in an effort to avoid losing money.

But as the speed of the share price slide accelerates, panic begins to grip the market causing others to follow suit. As everyone moves to offload stocks, supply exceeds demand causing prices to plunge across the entire stock market.

Research conducted by Robert Shiller, the Nobel Prize-winning economist, on investor behaviour in the 1987 stock market crash found that there was "a great deal of investor talk and anxiety around October".

Major events

Major world or geopolitical events can weigh heavily on investor confidence, prompting them to offload risky assets in favour of safe plays, such as gold or bonds. Unprecedented events can trigger panic-induced selling.

The Dow Jones fell by as much as 7.52 per cent in intraday trading on September 17, 2001 when Wall Street reopened following the 9/11 terror attacks.

Tightening of monetary policy

Central banks have rattled markets as they discuss withdrawing stimulus such as quantitative easing (QE) and hiking interest rates.

Hawkish rhetoric from Mario Draghi, the European Central Bank president, Bank of England policymakers and the US Federal Reserve has rocked investor sentiment in recent weeks. The ECB has confirmed it wants to taper QE and the US central bank wants to wind down its balance sheet.

In a recent note to clients, James Barty, Bank of America Merrill Lynch (BAML) investment strategist, said: "Markets do not like the sound of this. The central bank 'put' is being withdrawn and the knee-jerk response is one of concern. Bond yields have spiked from under 25 basis points to 57 basis points since the comments and the European equity market has had a distinct wobble. The US and emerging markets have joined in, albeit to a lesser extent."

But we've been here before: Mr Barty points to the "taper tantrum" of 2013, when bond and equity markets fell sharply after the US Fed began reducing the amount of money it was pumping into the economy. However, BAML believes if growth holds up in the global economy, tighter policy won't bring markets crashing down.

US investment bank Citi earlier this week also suggested that monetary policy could pose a threat if "central banks are perceived to be ahead of the curve", as they believe that would negatively impact investor confidence.

Overstretched valuations

Market valuations are overstretched. Using the metric developed by Professor Shiller and John Campbell, the cyclically adjusted price to earnings ratio or "Cape" - which compares a share price with the earnings of the company concerned over the past 10 years, adjusted for inflation - shows today's valuations have been surpassed only during the build-up to the dotcom bubble in 2000 and the 1929 Wall Street crash.

On another measure, the S&P 500's price-to-earnings (PE) ratio - which compares a company's share price with its earnings over the past 12 months - is 17.5 times forward 12 months' earnings.

Meanwhile, a recent BAML fund manager survey showed that a record number of professional investors think that world stocks are more "overvalued" now than during the 1999 tech bubble, which was famously described as "irrational exuberance" by Alan Greenspan, then Fed chairman.

After surveying 210 global fund managers in June, BAML found a net 44 per cent said equities were overvalued, up from a net 37 per cent last month, and beating the previous record high set in 1999's dotcom bubble.

Separately, a report by JPMorgan earlier this week revealed that analysts are concerned that second-half earnings may not be as robust as previously expected.

The US bank warned: "We note that in the US, the negative to positive earnings pre-announcement ratio is down to 1.9x, its lowest level in six years."

Analysts at the bank believe price-earnings ratios are vulnerable to a slowdown in earnings growth, highlighting that world price to earnings is 26 per cent more expensive than it was ahead of the Fed's QE taper in 2013.

Asset bubbles

Asset bubbles occur when prices become over-inflated, rising much faster than an asset's real underlying value. Last month, gripped by fears that the technology sector is in a "bubble", tech stalwarts suffered a sharp sell-off following a bearish Goldman Sachs note on the sector.

A survey of professional investors conducted by BAML found that three quarters of respondents said US and global internet stocks were either "expensive" or "bubble-like". The tech-heavy Nasdaq was seen as the "most crowded trade", BAML found.

Data showed that most money managers were "overweight" - or had a "buy" recommendation - on the so-called "FANG stocks" of Facebook, Amazon, Netflix, and Google.

Global economic slowdown

Signs of increased volatility across a number of risk assets and emerging markets are beginning to rattle investors.

Earlier this week, Citigroup warned that stock markets could be at risk if there is a global economic slowdown. Investors should remain wary as strategists point to the potential for slower momentum in China and mixed macroeconomic data from the US.

Algorithmic trading

While it has been around for a long time, algorithmic trading has taken a significant share of trading activity in recent years. Algos can often cause, or at least accelerate, dropping prices in markets, as there is no human input.

For example, last October's "flash crash" in sterling was caused by a combination of inexperienced traders, algorithmic trading and complex trading positions, a report from the international banking body the Bank for International Settlements found.

Are we heading for another titanic moment?

History suggests that stock markets always rally strongly before a crash. Other contributing factors can be harder to identify.

Last month, Fed chairman Janet Yellen said she believed we will not see another major financial crisis "in our lifetime" because banks are stronger. But not everyone agrees.

Marc Faber, the Swiss investor known as "Dr Doom", predicts that stocks will plunge by 40 per cent or more. Mr Faber, the editor of The Gloom, Boom & Doom Report, told CNBC recently: "We have a bubble in everything."

Prof Shiller has urged investors to tread cautiously because market valuations are at "unusual highs". In a recent interview with CNBC, he said: "We are at a high level, and it's concerning", highlighting that the only times valuations have been higher were in 1929 and 2000.

With fears growing of tech bubble 2.0, BAML attempted to assuage investors' fears. In contrast to the 2000 bubble, strategists at the bank reckon valuations "ain't irrational yet".

The Daily Telegraph, London

  • 1929: The Great Depression: In the worst crash in US history, the Dow Jones plunged 25 per cent in four days, starting on October 24. The Dow's descent continued until July 1932, by when it was nearly 90 per cent below 1929 highs.
  • 1987: Black Monday: The Dow dropped 22.6 per cent in a single trading session.
  • 2000: The Tech Bubble: The tech-heavy Nasdaq index fell by 78 per cent. Former US Federal Reserve chairman Alan Greenspan famously dismissed the stock market bubble as "irrational exuberance".
  • 2007-8: The Great Recession: The most recent titanic moment. It came to a head on September 29, 2008 when the Dow plunged 777.68 points in intraday trading. Two weeks earlier, the US had allowed Lehman Brothers to go bankrupt.