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3 reasons why this pullback could get much more severe

Editor's note: This post originally appeared on Business Insider.

Financial markets are on edge Friday morning after yesterday's bloodbath in momentum stocks.

On Thursday the Nasdaq suffered its worst one-day decline since November 2011 and is off 7% from its March high; the Dow and S&P 500 are down about 3% from their highs.

Related: Are social media stocks in a bear market?

Some signs suggest that this pullback — or another one sometime soon — could get much more severe. Why?

Three basic reasons:

  •         Stocks are still very expensive
  •         Corporate profit margins are at record highs
  •         The Fed is now tightening

Let's take those one at a time.

First, price.

Even after the recent drops, stocks appear to be very expensive. Does a high PE mean the market is going to crash? No. But unless it's "different this time," a high PE means we're likely to have lousy returns for the next seven to 10 years.

So that's price. Next comes profit margins.

One reason stocks are so expensive these days is that investors are comparing stock prices to this year's earnings and next year's expected earnings. In some years, when profit margins are normal, this valuation measure is meaningful. In other years, however — at the peak or trough of the business cycle — comparing prices to one year's earnings can produce a very misleading sense of value.

Today's profit margins are the highest in history, by a mile. Note that, in every previous instance in which profit margins have reached extreme levels — high and low — they have subsequently reverted to (or beyond) the mean. And when profit margins have reverted, so have stock prices.

Now, you can tell yourself stories about why, this time, profit margins have reached a "permanently high plateau," as a famous economist remarked about stock prices in 1929. And you might be right. But as you are telling yourself these stories, please recognize that what you are really saying is "It's different this time." And "it's different this time" has been described as "the four most expensive words in the English language."

And then there's Fed tightening.

For the last five years, the Fed has been frantically pumping money into Wall Street, keeping interest rates low to encourage hedge funds and other investors to borrow and speculate. This free money, and the resulting speculation, has helped drive stocks to their current very expensive levels.

But now the Fed is starting to "take away the punch bowl," as Wall Street is fond of saying.
Specifically, the Fed is beginning to reduce the amount of money that it is pumping into Wall Street.
To be sure, for now, the Fed is still pumping oceans of money into Wall Street. But, in the past, it has been the change in direction of Fed money-pumping that has been important to the stock market, not the absolute level.

Related: Short-term interest rates likely to stay near zero for 2 more years: David Kotok

In the past, major changes in direction of Fed money-pumping have often been followed by changes in direction of stock prices. Not always. But often.

For those who want to believe that Fed tightening is irrelevant, there's good news here: A sharp tightening cycle in the mid-1990s did not lead to a crash! Alas, two other tightening cycles, one in 1999 to 2000 and the other from 2004 to 2007 were followed by major stock market crashes.

One of the oldest sayings on Wall Street is "Don't fight the Fed." This saying has meaning in both directions, when the Fed is easing and when it is tightening. A glance at these charts shows why.
On the positive side, the Fed's tightening phases have often lasted a year or two before stock prices peaked and began to drop. So even if you're convinced that sustained Fed tightening now will likely lead to a sharp stock-price pullback at some point, the bull market might still have a ways to run.

So those are three reasons why the stock market could experience much more than a garden-variety "correction" — price, profit margins, and Fed tightening. None of this means for sure that the market will crash or that you should sell stocks (I own stocks, and I'm not selling them.) It does mean, however, that you should be mentally prepared for the possibility of a major pullback and lousy long-term returns.

Related: The market is rigged: Here's how not to be a victim

If the recent stock weakness turns out to be the start of a major pullback, don't say you weren't warned!

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