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A 40% Drop in Stocks Would Pop This Bubble, but a Slow Deflation is More Likely Than a Sudden Crash

June 19, 2024
minute read

Currently, the likelihood of a U.S. stock market crash is below average, according to "froth forecasts" from State Street Associates, based on Harvard University professor Robin Greenwood's research. They define a crash as a 40% decline over the next two years, and the current probability is calculated at 18%, compared to the five-year average of 26%.

This below-average probability extends to the high-tech sector, which has recently seen significant returns and has been the focus of many bubble predictions. State Street calculates that the crash probability in the high-tech sector is four percentage points lower than the five-year average.

Highlighting these probabilities is important due to the recent increase in bubble predictions on Wall Street. Many of these predictions lack a precise definition of a bubble and rigorous criteria for what constitutes a crash. Yale University's Will Goetzmann points out that without these criteria, bubble predictions often reflect more about the analysts than the actual crash probabilities.

Greenwood's and State Street's crash probabilities are linked to the stock market’s performance over the past two years. As past performance increases, so does the probability of a subsequent crash. For instance, a 100% run-up in the trailing two years leads to a crash probability close to 50%, while a 150% run-up almost guarantees a crash. The S&P 500, however, has had a cumulative return of 48.9% over the past two years, which is significantly below the levels associated with a high crash probability.

Addressing market concentration, some analysts argue that the significant performance difference between the cap-weighted S&P 500 and the equal-weight version signals an unhealthy market prone to a decline. This year, the cap-weighted index has outperformed the equal-weight version by over 10 percentage points, and last year, the difference was more than 12 percentage points. This suggests that the cap-weighted index's performance is increasingly reliant on its largest stocks.

However, an analysis of data since 1970 does not support the idea that market concentration signals an imminent crash. The analysis shows no consistent pattern between the outperformance of the cap-weighted S&P 500 and its subsequent performance over the next two years. Statistical analysis indicates no significant correlation at the 95% confidence level, commonly used to assess genuine patterns.

This does not imply that the U.S. stock market is free of challenges. It remains extremely overvalued, but there are numerous ways for the market to address this overvaluation other than a crash. According to the State Street Froth Forecasts, it is likely that the market will correct its overvaluation through other means, such as a prolonged period of mediocre performance.

In conclusion, while bubble predictions are increasing, the current data suggests a lower-than-average probability of a U.S. stock market crash. Both the overall market and the high-tech sector show probabilities below their respective five-year averages. Market concentration does not necessarily predict a crash, and the overvaluation of the market can resolve through various means without resulting in a dramatic decline. The insights from State Street and Greenwood offer a more nuanced view, suggesting that the market might adjust through steady, less volatile changes rather than a sudden crash.

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Adan Harris
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Adan Harris
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