Where the Next Stock Market Crash Will Come From

In an economy, there are two main ways to transfer funds from those who have too much to those who need funds: credit and equity. Banks and stock markets are the institutions that facilitate this vital economic process. If there is a problem with one of these institutions, the economic outlook becomes bleak, and the chances of a recession increase dramatically. As long as one is functioning well, then in the event of a recession or market crash, stocks should recover. As an example, think back to the GFC; nobody trusted banks, there was a liquidity crisis, stocks were down all over the world, and things stayed that way until banks started to report profits in Q1 ‘09. Everything else was just politics and sentiment—what finally turned the tide was banks becoming healthy and functional again.

The reason why the recent high interest rates environment didn’t break anything is because the stock markets worked fine and high interest rates were good for banks. Everybody kept expecting something to break, and something did crack: regional banks. The regional banking crisis of March 2023 happened because of this expectation. Once the dust settled, it became apparent that while banks like SVB had huge unrealized losses, it was the bank runs that led to their collapse. Bank runs were the problem, not the unrealized gains. Hence why the BFTP facility worked great.

Ostensibly, banks are much safer now because of a lot of regulations and Basel III. We’ll see. What this means is that in theory, the next market crash will come from stocks. The last time this happened was in 2020 at the start of Covid. The S&P 500 index peaked on Feb 19th and lost a third of its value in one month. For context, in the subprime crisis, it peaked on October 9th, 2007, and took one year to lose a third of its value, and in the dot-com crisis, it peaked on March 24th, 2000, and took one and a half years to lose that amount. So the Covid crash was horrible.

What was perhaps more remarkable is how quickly stocks recovered from the crash. Stocks dropped from Feb 23rd to March 20th and began to recover after central banks intervened from March 23rd to 20th April. Stocks were down so it was up to the banks to ‘save the economy’, according to our framework. Since nothing was wrong with banks, the market crash was bound to recover. I’ve put save the economy in quotes because really what the rate cuts did was stop the market crashes and not save the economy, but the premise for why the crashes stopped is that the cuts were expected to boost the economy.

Remarking on these events at the time, Krugman opined in a NY Times article: “Whenever you consider the economic implications of stock prices, you want to remember three rules. First, the stock market is not the economy. Second, the stock market is not the economy. Third, the stock market is not the economy.” He also remarked that the stock market is driven by greed and fear, and its connection to real economic growth has been somewhere between loose and nonexistent. I wouldn’t quite say this is absolutely true. The stock market provides companies with equity capital, which they then invest to make even more profit, which makes them more valuable and attracts more investors, which increases their share price, which gives them more equity capital… So stonks keep going up; Investors have short memories and there is a fresh bunch of new investors ready to latch on to any growth prospects a company might have.

Companies are focused squarely on profits, whether they get funds from banks or the stock market, so while investors are playing their little games in the land of fear and greed, hard-working men and women take commutes and clock in and work hard to maximize shareholder value. Then every quarter they publicize their performance and that’s when the fear and greed begin. My point is that there are real companies behind all those tickers, that do real things.

My focus is on why markets crash. I would argue that markets crash when none of the companies in the stock market can save the economy.

In 2020, the markets crashed because no company had a readily available COVID-19 vaccine to prevent the lockdowns and subsequent economic turmoil. In the subprime crisis, the markets crashed because no company, or set of companies, could provide the liquidity needed to fix the financial system. In the dot-com crisis, the markets crashed because no company was making any money from the Internet. In all these cases, the markets crashed when it became apparent that no company could prevent the broader economic collapse.

Looking at things from this framework, the reasons for a crash are not just investor fears, although that certainly plays a part; it’s whether or not the companies that make up the stock market can mitigate a threat to economic stability. That’s what breaks the camel’s back.

So where will the next market crash come from? First, we have to keep in mind the words of Krugman and note that a market crash and a recession are not interlinked, and if so, very loosely. There are already speculations on what could bring about the next recession. For instance, Jared Dillian, editor of The Daily Dirtnap and author of several books, thinks it will come from private equity (more about that here). There are layers upon layers of debt in private equity (see the following FT article for example) and they’ve been paying high interest rates. It’s a ticking time bomb. Maybe that will do it, but stocks will only crash if it is apparent that no company in the stock market can mitigate this from happening.

There are speculations that the AI bubble will pop bringing down tech stocks, chief among them being Nvidia. That could cause a crash if it happens but only if many companies are not making money from AI.

The problem with these kinds of speculations is that they are known in advance. I don’t remember what it’s called but there’s a phenomenon where if something bad is expected to happen, it doesn’t end up happening because the expectation of it led to preemptive action. Once a potential problem is identified, some company or government institution will work on a solution and the problem won’t materialize. So the next market crash is likely to come from something unexpected. But, if you want to be systematic about your speculations, and you have the time and resources, here’s what you can do. Look at the companies listed on the stock market, especially the big ones. Look into what they do, and try and find out what are the things that can happen and none of the companies would be able to help us. That’s where the next market crash will come from.