WARNING: Rising Interest Rates Could Cause a Market Crash in 2021

The stock market is overpriced, and one of the elements contributing to this is the inevitable rise in interest rates.

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COVID-19 brought about one of the sharpest market crashes we’ve seen in decades, and the quick market crash was followed by a nearly equivalent rapid recovery. The S&P/TSX composite index was up 35% within 40 days of the crash. After that, the growth started to slow down. In the next seven months, the index only grew about 14.8%.

Though a lot of investors made a lot of money by buying the stocks that hit rock bottom and selling as soon as they reached their recovery peak and the momentum slowed down, the more accurate growth pace wasn’t the first phase of the rapid rise but the second, more modest growth pace. A small dip in the tech sector in September shook investors out of their growth reverie, because tech led the rapid recovery, and its fall could’ve meant the early signs of another crash.

It turned out to be nothing, but now, a more pragmatic marker of an impending market crash is becoming more apparent.

Interest rates and market crash

Governments worldwide dealt with the economic devastation market in different ways: stimulus checks, tax submission delays, financial aid to businesses, and cutting down interest rates. It was expected to stir people into action, benefit from the low interest rates, and, consequently, get more money rolling into the market. This was expected to sustain and recover the devastated economy.

And it worked in some ways, but some skeptics were saying it wasn’t the right solution for several reasons. Those fears are reflected in the recent predictions of a Bay street veteran economist and strategist. He claims that once the interest rates start to rise again, the stock market rally and the powerful recovery it has shown in 2020 might halt in its tracks.

He claimed that this bubble is already stretched thin, and the needle of the rising interest rates might be enough to poke it. A weird stat that endorses this prediction is the fact that the S&P 500, which reached 3,700 a few days ago, would have been 3,200 if the market didn’t crash in March. So, when the underlying economy is weaker than it would have been if there wasn’t a crash, the stock market has risen higher!

Best way to prepare

It would be risky to suggest that investors should sell the recovery stocks that have reached their peak and create liquidity to balance the portfolio and for buying stocks in another crash. But a market crash would offer excellent opportunities to buy great companies at a low price. One temperamental stock you may want to keep an eye on is Facedrive (TSXV:FD).

It’s a new company, and since its inception on the venture exchange in Dec. 2019, it has grown over 650%. The reason you may want to consider this stock is its powerful recovery potential. During the last crash, the stock fell over 43%. Right now, the stock is quite overpriced, but another market crash can offer a similar discount.

Foolish takeaway

The difference between the stock market and the underlying economy is quite large and getting larger by the day as the economy struggles while the market soars. Even if the bubble doesn’t burst per se, and we don’t see a sharp market decline as we did in March, the market might stagnate for a long while or start on a low-angled downward journey. If that happens, dependable growth stocks might fare much better than robust growth stocks.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Othman has no position in any of the stocks mentioned.

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