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Don't Ignore These Stock Market Crash Risks

Wall Street likes to downplay the idea of a stock market crash and the risks associated with a significant fall in share prices, but the truth is that bear markets and sharp price declines can and do happen with some frequency.

As investors, we cannot afford to blithely ignore the possibility and potential for a negative market event to damage our long-term plans. That's when investors see their net worth cut by half or more – which has happened twice in just the last decade.

We need to be aware of when the risks of a big decline are rising and take measures to protect our net worth.

This is such a time.

Stock Market Crash Risks are On the Rise

Although the stock market does not appear to many analysts to be severely overvalued, there are very real risks to the economy and the market.

For example, if no compromise is reached to avert the fiscal cliff, the Congressional Budget Office estimates that the combination of spending cuts and new taxes could shave as much as four points off gross domestic product growth and push us back into recession. Plus, taxes on dividends and capital gains will increase sharply and could well make stocks less attractive to investors.

MIT Finance Professor and corporate valuation expert Aswath Damodaran recently did a study of the potential impact of the new tax structure. He found that the increased taxation reduced the value of stocks by 7% to 30% depending on the yield of the individual security. The higher the yield, the more of a haircut to the value of the company.

Even if the president and Congress are able to reach a compromise that avoids the dreaded cliff there are still large potential negatives for the stock market. Most investors value stock on earnings and potential growth, but the weak U.S. economy is limiting growth opportunities.

As third-quarter earnings reports have shown us the economy is not strong enough for companies to improve their top or bottom line. Most of the S&P 500 companies have reported and average earnings are down more than 2%, with revenue down by almost 4% on a year-over-year basis. It has been the weakest earnings quarter since 2009.

READ: Most of us – and our money – are dangerously exposed to a stock market crash.

The stock market also has substantial headline risk right now.

We have seen sharp selloffs caused by news out of Europe the past few years and it is highly liley we will again as we head into 2013. We'll see more talk of defaults and civil unrest out of Greece before too much time passes. Spain and Italy are still experiencing sell offs and even the German economy is showing weakness.

The situation in the Mideast is still very unstable as the region teeters between Arab Spring and global nightmare. Headlines from any of these regions could easily cause selling panics and extended price declines in U.S. stock prices.

One of the biggest reasons we may well see a bear market raise its head in the next year is the fact that we are simply due. Declines of 20% or more in the market usually occur every three-and-a-half years or so.

We have not had one since the market bottom in 2009. We saw decline of more than 10% on several occasions and a 17% drop in the late summer and early fall of 2011. The market has better than doubled off the 2009 bottoms without a meaningful and lasting sell off.

A 20% drop now could take us to an S&P level of around 1,180 or a Dow Jones Industrial Average price of 10,300 or lower.

Now it seems that the economic and market specific catalysts are falling into place for a stock market crash, and risk is higher than any time since the last significant market top in 2007.

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  1. steven waters | January 2, 2013

    so long as investors want profit at the expense of others there will be an imbalance. the rich get richer and poverty is growing. we are polluting the earth and destroying the future for our children. this unbridled need for consumerism and the greed to have will be our undoing. in the last few decades we have seen the boom and bust cycle getting closer and closer together. each time we have stimulated ourselves out with govt support and control from the central banks. each time we hit the bottom and companies close and there are job loses and people suffer we do the same thing again and again building up to the boom time again. things get over valued, banks lend out money we over extend ourselves and it starts all over. until we realize and stop trying to make money on everything we do and make money at the expense of the planet and people it will be the same. the whole monetary system needs to be changed. we need to share more and help those in need. we have enough to share with food by growing programs and doing away with the waste because of the market dictating that the food be wasted because its not worth anything to the company well its worth a lot to the hungry. until we work together in co-ops and take care of each others needs first and change our priorities to people first not profits then the market will keep crashing because its based on a false and uncaring system. eventually there will be a big crash as the system cannot work anymore. despite it giving us prosperity countries are going broke and people begin to ask what is money really worth its not solving our problems its making it worse. this system is destroying communities and many are dying unnecessarily. unfortunately this will keep happening because of greed by some who dictate to the many that this is how its gonna be. instead of giving the power to the people and allowing them to do whats best for each other they will tell us what and when to do it. a centalised money system which is controlled by the small wealthy and powerful group who don't have our interests at heart just more power and control. in the end even they will not stop the eventual fall of the system because its based on a lie and it will come down like a house of cards.

    • Eileen | January 6, 2013

      Steven, your comment may be inspirational and is a generally good guiding direction – but it lacks any reference to the diverse personalities out there. I'm willing to bet that you probably don't need much help in your life, and if/when you do need help you make the most of it and go return to being productive. However, there are many personalities that are only prodded into productivity when there is no other alernative. Some of the problem stems from poor governing: otherwise able people have been raised with a mindset that makes them cling to welfare almost with the same fervor that others cling to actual jobs.
      Co-ops only work when the people in the co-op work to the best of their ability to improve one another's living standard. However, a successful group at providing for their own needs – and willing to share – will attract "less than ambitious" participants in a very short time. Then the conflict begins, as it did with some many of the communes. Again, it's often times a personality (culture) difference. Some people just can't understand working too hard, but these same "slackers" have no problem accepting the fruits of the labor from those who do work…and even insist on getting equal shares.
      If my feedback sounds cynical, I suppose it is. But you can't say it doesn't reflect reality.

  2. Jim Madden | January 13, 2013

    Until the people with money are rumbled we will go through this for decades to come. The Bankers who over stretched all established limits on borrowing and trousered the hugh profits are still there in the higher levels of banking. Only today I read that the Bankers are putting off thier bonus payments (Yes bonuses) due in March until after April so they only pay 45% tax and not the current 50%. I did some research trying to find out who we owe all this money to I cannot find that out, it is not the Chinese or the yanks, because their debt is higher than ours. Could you ever owe yourself money…… eems we do.

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