Is there a risk of a new stock market crash?

As the financial markets continue to be impacted both by the debt crisis in the US and the ongoing Greek crisis that now threatens to envelop Italy as well, it appears legitimate to wonder whether we are heading for a new crash or not. French economist Patrick Arthus offers his analysis on the current situation:

What are the causes for concern of a new crash?

• Slowdown of liquidity

The end of the Quantitative Easing 2 (QE2) program launched by the US Federal Reserve, which signifies the end of the rapid growth of the US monetary base, will lead to a decrease in the amount of money that is funneled into the stock markets.

• Downward revisions of the growth

Expected growth in 2012 is still quite strong, while growth in 2011 was already significantly revised downward in the United States and the United Kingdom but not in the euro zone. Arthus fears that growth in 2012 might be weaker than expected due to:

– A decline in creditworthiness of indebted US households caused by falling house prices.

– The enforcement of restrictive budgetary policies in euro zone countries and the declining of real wages that comes as a result.

– A decline in world trade with a drop in activity in China and Brazil due to restrictive monetary policies.

• Higher risk aversion

The risk aversion could increase in two cases:

– If the European public debt crisis engulfs other countries besides Spain such as Portugal, Ireland or, more recently, Italy.

– If there ends up being a real public debt crisis in the United States.

•  Dollar depreciation risk

Currently, the dollar is depreciating vis-à-vis almost all currencies, but much less vis-à-vis the euro due to the sovereign debt crisis in the euro zone. If the US were to suffer some sort of major economic setback or if the sovereign debt crisis is resolved, the risk of a more rapid depreciation of the dollar against the euro could come to be a reality.

What are the reassuring factors against a new crash?

• The stock markets are undervalued

When we look at recent levels of equity risk premiums, we can see that the stock markets are highly undervalued, with a high margin of safety that could absorb large shocks, such as a rise in long-term interest rates due to the end of QE2.

•  High dividend rates

The high dividend yield in the euro zone makes European stocks attractive even in the absence of a surplus value in capital.

•  Change in profit sharing

There has been a shift towards companies offering a higher percentage of corporate earnings to their shareholders. The recent rapid growth in earnings per share is largely due to this change in profit sharing which has come at the expense of the employees working in these companies. This change continues today thanks to the high rate of unemployment and the lack of negotiating power of many of these employees. As such, investors should continue to observe a rapid increase in corporate earnings.

Conclusion:

After examining the case for and against the likelihood of a new stock market crash, it appears that due to the high risk premium that currently exists in this undervalued stock market climate, all potential negative effects from the current economic situation seem to have already been taken into account by the markets and thus we can safely say that the risk of a new stock market crash seems marginal at this point.

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