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The US stock market’s close to another all-time high, at least when looking at the S&P 500 index. That’s terrific for anyone who’s been snapping up shares in recent years.
However, despite the seemingly strong investor sentiment, there are some potentially massive risks being overlooked, several of which could even trigger a full blown crash later this year.
Major red flags
There are several concerning trends that the market is seemingly ignoring. I think the three biggest are:
1. Rich/fragile valuations
The investment management company Pimco has recently calculated the cyclically adjusted price-to-earnings (CAPE) ratio of the S&P 500 to be in the 94th percentile. That’s a fancy way of saying US stocks are trading at earnings multiples significantly higher than their historical average. And historically, such a high CAPE has been a prelude to major market crashes as in 1987 and 2000.
2. Inflation
At the same time, new tax cuts and higher government spending in the US during a time of fiscal instability and tariff uncertainty create a lot of complications for the Federal Reserve. With fears of inflation potentially making a comeback, the central bank could be forced to start hiking interest rates again. And that might spark a fresh wave of corporate defaults given the growing bubble of overleveraged balance sheets.
3. Geopolitical tensions
Beyond brewing trade wars, conflicts have started popping up across the globe, particularly in Eastern Europe and the Middle East. Continued escalation of tensions could lead to even further supply chain disruptions, oil price shocks, or a capital migration to gold, which could spark significant volatility in the stock market – particularly among the businesses trading at lofty valuations.
How to prepare
As we approach the end of summer, the impact of current macroeconomic uncertainties is expected to emerge. That means September could be the tipping point. Does that mean a crash is guaranteed to happen? Of course not. Geopolitical tensions could calm while economist forecasts could be completely wrong (it wouldn’t be the first time).
So what should investors do? Trying to time the market is a strategy that almost never works. Instead, holding through the storm has been a far more successful strategy in the past. Having said that, trimming large portfolio positions might be prudent, especially if the stocks are trading at a lofty valuation.
Take Nvidia (NASDAQ:NVDA) as an example. The GPU chip designer has been one of the best-performing US stocks over the last five years, thanks to skyrocketing demand for its technology. The explosion of artificial intelligence (AI) infrastructure investments by data centres has translated into triple-digit profit growth, propelling the market-cap well beyond $3trn.
However, economic turbulence from the macro-environment could cause AI-related spending to slow significantly. That could potentially wipe out a significant chunk of its income stream. In such a scenario, a sharp share price drop wouldn’t be surprising – especially for a company operating in the cyclical semiconductor space. That’s why investors with a large position in Nvidia today may want to consider potentially trimming their exposure.
If a crash does emerge, there are going to be some fantastic, high-quality companies going on sale. And by having a watchlist to top up on top-notch stocks, investors can be ready to consider incoming bargains like (possibly) Nvidia if they’re not already invested.
