Why the FTSE 100 could crash to 5,000

Veteran investors, like octogenarian Lord Rothschild, have been concerned about government and central bank policies since the financial crisis. As he has noted: "The unintended consequences of monetary experiments on such a scale are impossible to predict."

The distortions to asset valuations created by these experiments have made rational capital allocation very difficult on anything other than an opportunistic basic -- for example, riding the equity wave that has taken earnings multiples of major stock market indexes far above their long-term average.

Just this week, veteran equity income specialist Neil Woodford has also come out and said we're in an investment bubble. He refers, like Lord Rothschild, to the "biggest monetary policy experiment in history" and a "valuation stretch in markets now at extreme levels."

Irrational exuberance

Woodford also refers to the Bitcoin mania as one of numerous flashing red lights of irrational exuberance, something which Luke Johnson, veteran entrepreneur and chairman of private equity house Risk Capital Partners, has also written about recently.

Meanwhile, over in the US, legendary investor Warren Buffett has found so few attractive opportunities in the market that cash held by his Berkshire Hathaway investment vehicle has risen to an unprecedented $100bn.

Companies abrogating responsibility

It's not just investors in stock market companies who are struggling to gauge the intrinsic value of monetary-policy-distorted assets. Companies, too, are finding capital allocation hugely problematic. So much so that they're channelling an increasing proportion of earnings simply to dividends and share buybacks. As Martin Sorrell, veteran boss of FTSE 100 giant WPP, has noted: "Effectively management is abrogating responsibility for reinvesting retained earnings back to share owners."

When so many experienced and knowledgeable figures are talking of overvalued markets, asset bubbles and flashing warning lights, I believe humble private investors should take note but not panic.

Preparing for a crash

I'm not planning on liquidating all my assets and sitting on cash, waiting for markets to crash and bubbles to burst. For one thing, timing the market is notoriously difficult and, for another, I'm still seeing decent value in some areas. As, indeed, are the likes of the great investors I've mentioned above. For example, Neil Woodford reckons UK domestic cyclicals are seriously undervalued.

I'm not quite sure I agree with Woodford about that but then I'm not an equity income fund manager, who has to find somewhere in the equity market to put his fundholders' money. Investors with no restrictive mandate to meet can afford to be more circumspect.

As valuations become more stretched and attractive investments fewer in number, disciplined investors should naturally find themselves holding more cash, even if it's not quite as much as Warren Buffett's $100bn! And for most of us who are investing for the long term, big market corrections or crashes should be welcomed as an opportunity to deploy as much spare cash as possible to invest in great companies at bargain prices.

It's entirely possible the FTSE 100 could crash from its current 7,394 level to 5,000. But by maintaining investment discipline, being prepared and not panicking, we should be in a good position to profit from it if it does happen.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Berkshire Hathaway (B shares). 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.

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