Right now, I’m preparing my portfolio to deal with a stock market crash. I think there’s a real chance that a sharp decline in share prices could be just around the corner.
Banks
The major US banks report their quarterly earnings this week. I’ll be keeping a close eye on what they say.
Banks play a central role in economic activity. As such, their reports are often seen as a good indicator of the state of the wider economy. If the bank reports indicate that the US economy is slowing substiantially (or that it is about to) then I think that a stock market crash could be imminent.
A bleak economic outlook could cause estimates of corporate earnings to come down. And I think that lower earnings estimates is likely to result in lower share prices.
Share prices
In the first half of the year, stocks have been falling due to high inflation and rising interest rates weighing on share prices. Despite this, analyst expectations for corporate earnings remain strong.
Take Alphabet (NASDAQ:GOOG) for example. Of the 13 analysts offering earnings forecasts for Alphabet this year, only one has revised their forecast down recently.
Alphabet’s share price has fallen by 17% since the start of the year. As a result, the stock now trades at $2,400 per share.
The company is forecast to generate $110.62 in earnings per share this year. The current share price therefore implies a price-to-earnings (P/E) ratio of around 21.
At this level, I think Alphabet shares look like good value. As a result, I’ve been buying the stock this year.
Earnings
The difficult economic environment might cause Alphabet’s earnings to come in lower than expected, though. If this happens, the stock starts to look expensive.
Alphabet’s earnings this year coming in at $100 per share would mean that the current share price implies a P/E ratio of 24. Earnings at $90 mean the P/E ratio is 27.
At these levels, Alphabet stock looks much less attractive. So if it seems that Alphabet’s earnings are going to be closer to $90 than $110, I expect the stock to fall significantly to compensate for this.
It isn’t just Alphabet stock that I’m expecting this from. I think that a decline in expected earnings might well lead to a crash in share prices across the board.
A stock market crash?
So far this year, share prices have been falling as rising interest rates weigh on valuations. Stocks look cheap right now because they trade at lower P/E ratios than they used to.
If earnings expectations come down, P/E ratios will increase and stocks will look expensive again. I think this will cause share prices to crash.
I think that the earnings reports from the major US banks this week might cause expectations of future earnings to fall. As such, I’m preparing for a stock market crash in the near future.
