A stock market crash could be on the horizon. Here’s why

It was a big week for financial markets just gone. The reason is simple on the surface: inflation. It’s the key risk for investors like myself this year. And I think it could very well lead to a stock market crash. Not to mention prominent investors calling out that there’s a ‘superbubble’ right now! It’s in stark contrast to the huge returns that stock markets achieved after the Covid crash from March 2020.

So here, I’m going to look at the key risk as I see it today. Then, analyse whether I could still buy cheap UK shares if a stock market crash does happen.

A major risk: inflation

It was fresh inflation data from the US last week that spooked markets. The Consumer Price Index (CPI) came in at 7.5% year-over-year for January. This was more than forecast, and an increase from the 7% reading for December. The large-cap S&P 500 index was up for the week before the CPI release, but fell 3.7% to end Friday after the announcement.

Inflation is clearly spooking stock markets right now. And for good reason. It was all the way back in 1982 the last time US CPI rose so quickly. But why does high inflation really matter for the stock market? Well, it can erode company profits and raise costs. It can also dampen consumer sentiment, which impacts sales.

There’s another factor, though. And it’s what a central bank will do to try and curtail price rises. For example, the Federal Reserve (the US central bank) is expected to raise interest rates at least four times this year. In fact, the last time CPI was 7.5% in 1982, the Federal Reserve’s interest rate was 15%! That’s a lot higher than the 0.25% today, and gives huge scope for aggressive interest rate rises this year. This generally leads to a slowdown in economic growth and falling asset prices.

It’s not all about the US either. The UK CPI rate is expected to reach a peak of 5.8% this year. The Bank of England has already raised interest rates twice since December, too.

Here’s what I’d do if we see a stock market crash

But as a long-term investor, I’m not worrying too much. In fact, if a stock market crash does happen, it could throw up some excellent bargains for my portfolio. As an example, I’ve got Microsoft on my watchlist to buy if the share price falls.

The UK market is also far cheaper than the US right now. For example, on a forward price-to-earnings ratio, the FTSE 100 is valued on a multiple of 12, whereas the S&P 500 is trading on a much higher ratio of 20. Therefore, I see far more likelihood of a stock market crash in the US large-cap index when compared to the UK equivalent.

Nevertheless, if the UK stock market does crash, I’ll look for bargain shares. Companies like Segro and YouGov look richly valued today, but could be compelling buys for my portfolio if we see a crash. Just as long as I’ve thoroughly researched the companies before I bought any shares, I’ll be comfortable shopping for bargains.

Dan Appleby has no position in any of the shares mentioned. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK has recommended Microsoft. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.