3 Catalysts That Could Cause Stocks To Drop 20%

David Dierking

Investors probably liked what they saw in the portfolios in Q2. Stocks rebounded strongly off of the bear market low and even fixed income products didn't do too badly.

For many, the 20% gain for stocks in Q2 signals a return to good times and an economic recovery that could propel the averages to new highs.

I hate to be a wet blanket, but you might want to temper expectations.

Most of the Q2 recovery has been based on virtually unlimited stimulus and liquidity from the Fed and the expectation that reopening the economy will return us to pre-COVID levels of activity.

The former could result in dangerous collateral damage, while the latter might not be realistic.

Investors are pricing stocks for perfection right now and any event that rocks the boat could have serious repercussions for financial assets.

Here are three catalysts I'm watching that could send stock prices tumbling during the 2nd half of 2020.

A 2nd Wave of COVID-19 Continues to Spread

Stocks didn't really begin to suffer during the earlier bear market until it became inevitable that things would need to shut down in order to control COVID's spread.

Stocks recovered on the belief that once the economy reopened, it was signaling a decline in the spread of the coronavirus and a return to normal levels of economic activity.

But what if that turns out to be a false positive?

COVID cases are spiking again to levels we haven't seen yet and states, such as Texas, Florida and Arizona, are re-instituting restrictions to get things back under control.

As was the case in February, investors might be in denial that a second economic closure could be coming and aren't reflecting the possibility in stock prices until it becomes inevitable.

If that happens, stock prices could fall sharply and quickly like they did in Q1.

Joe Biden Wins the Presidency in November

Speaking apolitically, there's little question that the Trump presidency has been good for business. Conditions have been set up ideally for corporations to reduce tax burdens, eliminate costly regulations and grow profits rapidly.

That could change if Joe Biden wins November's election.

Democrats have already begun going on record saying that the recent corporate tax cuts could be in danger if they're able to gain control of the White House and Congress in 2020. In that scenario, S&P 500 are expected to fall roughly 20%, which could correspond to what happens in stock prices as well.

Valuations Begin to Reflect the Economic Environment

The recent rally has been almost entirely thanks to the Fed. They've loaded up this economy with so much cash that it's creating an artificial sense of calm and confidence among investors.

But that cash has consequences - a falling dollar, higher inflation, a potential spike in interest rates. The Fed has gone to great lengths to keep the bubble inflated and it's created a huge disconnect between the current state of the economy and the current valuation of equities.

If those two become connected again, it's easy to see stock prices declining 20% or more to get back in line.

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