Next stock market crash will look different than the financial crisis

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trader upset 2008 financial crisisReuters
/ John Gress

  • The stock bull market is well into its ninth year, and
    signs of fragility have firms like Bank of America Merrill
    Lynch looking ahead to the next big crash.
  • By BAML’s calculation, the next bear market will be in
    line with past occurrences, and nowhere near as volatile as the
    2008, 1998 or 1987 crashes.

Stock bull markets don’t last forever,
which is why it’s a useful exercise to start bracing for the next
big crash. Or at the very least, it’s helpful to know what kind
of damage could result from the inevitable downturn.

In order to do so, Bank of America Merrill Lynch looked at past
S&P 500 bear markets —
generally defined as a 20% drop — and analyzed the volatility that has accompanied them.
To them, the key is looking at the degree of price swings leading
up to the crash.

And based on the fluctuations seen during the ongoing 8 1/2-year
bull market, the firm forecasts volatility of 18% for the next
large downturn, which is right in line with other “classic” bear
markets.


Screen Shot 2017 12 06 at 4.05.35 PM
BAML says that, based on
the current bull market’s volatility, the next bear market will
see volatility of 18%.

Bank of America
Merrill Lynch


Of course, there’s always the risk of a rare occurrence that
rocks the market and sends measures of volatility spiking. BAML
notes that the Great Depression of 1929 and the global financial crisis (GFC) in 2008
were driven by major systemic shocks, while Black Monday in 1987
and the collapse of hedge fund Long Term Capital Management in
1998 were caused by liquidity-driven meltdowns.

Fear not, says BAML. For one, the market is not at risk of a GFC
repeat. The firm says that the huge regulatory response to the
crisis, bank deleveraging, and risk transfer to central banks
have alleviated the pressures that contributed to that crash.

As for the massive selloffs in 1987 and 1998, BAML argues that
volatility at present time is simply too low to match the
conditions that preceded those disastrous periods.

“History shows that a shock of this magnitude has never occurred
from the current level of volatility,” a group of BAML
derivatives strategists led by Benjamin Bowler wrote in a client
note.


Screen Shot 2017 12 06 at 4.22.25 PM
BAML says that the current
volatility regime is nothing like the ones seen before the 1987
or 2008 crashes, and therefore the market isn’t at risk of
selling off to that degree.

Bank of
America Merrill Lynch


But this doesn’t mean it’s time to get cocky. Just because the
next bear market is likely to be subdued relative to the worst in
history doesn’t mean it won’t be painful. After all, as BAML
points out, “markets remain fragile.”

So as the current bull market extends well into its ninth year,
investors would be well-served to keep an eye on the risks that
are still out there, lurking in the shadows. Luckily, Morgan
Stanley has identified “three x’s” that could send
stocks into bear market territory: extreme leverage build-up,
exuberant sentiment and excessive policy tightening.

Got all that? Good. Now go protect to the downside, just in case.

Source

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