The 3 Forces Behind a Market Crash

Only a couple of months ago, many of the market's averages were hitting all-time highs: the Dow Jones Industrial Average, other broad large-cap indices such as the Russell 1000 or S&P 500, mid-cap indices such as the S&P Midcap 400 Index, and smaller-cap indices such as the S&P SmallCap 600 and Russell 2000. But in the weeks and months since then, market bulls have felt a lot of volatility and pain, continuing right through today's market action.

And so we've heard a lot of talk lately about whether we're seeing the start -- or, perhaps, whether we're already part of the way through -- a market crash. The market's actions over the past couple of days have added fuel to the fire. If there are sound reasons to fear a full market crash, then it's time to come up with a decent alternative to sinking new money into the market.

Indications of a coming crash

Back in 1934, Benjamin Graham, the creator of securities analysis, wrote that there are three forces behind a market crash.

The manipulation of stocks.
The lending of money to buy stocks.
Excessive optimism.

Let's assess the level of each factor today

1. The manipulation of stocks

Graham was quite familiar with this factor, since it played a key role in the market crash of 1929. Before the SEC was created in 1934, the federal government exerted very little regulation over the markets by -- and what little existed was patently ineffective.

Things have markedly improved since then. However, because of the vast amounts of money people so quickly made at the end of the '90s, those who followed the market closely were taking various market manipulations for granted. The broad manipulation of the IPO market and the trading of favorable research reports for investment-banking work by Wall Street's top (and middle and bottom) analysts were just two of the contributing factors to the crash that lasted from 2000 to 2002.

Today, however, there is far less potential for market manipulation. A better-staffed SEC; new regulations on the books, including Reg AC (requiring a greater level of disclosure by analysts); the structure of IPOs; and even Sarbanes-Oxley (expensive, but effective) mean that whatever manipulation happens in today's market is largely relegated to micro caps.

2. Lending money to buy stocks

Excessive use of margin contributed to the market collapse in the early part of this decade, and it was also a main culprit in 1929. Back then, an investor only had to have 10% equity and 90% margin to buy stocks. Low interest rates have also led to excessive lending over the past few years in the housing market -- and they were a contributing factor to the tech bubble of several years ago.

I have to admit that this factor remains somewhat troubling today. According to a recent Barron's article, there is a higher level of margin debt for the NYSE and Nasdaq today than at any previous time -- $303 billion, just slightly higher than the peak of $300 billion set in March 2000 -- though, figuring in inflation, it's not setting any records. I'd keep an eye on this factor, but I'd measure its effect through the lens of the third factor.

3. Excessive optimism

Given the current price-to-earnings multiples out there, even the most downcast curmudgeon simply can't argue that today's prices reflect excessive optimism.

Stocks are squarely in the range of normal P/E multiples, while they continue (at least this past quarter) to realize earnings growth that is higher than the historical average. Moreover, the companies behind these stocks sport record amounts of cash on their balance sheets and continue to increase their reserves even as they repurchase shares, pay dividends, or both.

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