There's a 'critical variable' that will determine when the next stock market crash strikes - and one expert says it could erase 10 years of progress sooner than anyone thinks

Reuters / Cheryl Ravelo-Gagalac

• The stock market is back within 2% of record highs, but one market expert says this strong performance is masking a major issue lurking under the surface.
• Doug Ramsey, the chief investment officer at Leuthold Group, is focused on a "critical variable" he says is closer to a dangerous tipping point than most people realize.
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Now that the stock market has recovered from it's vicious December sell-off and climbed within 2% of a record high, it's easy to see what some investors are feeling optimistic.

But Doug Ramsey, the chief investment officer at Leuthold Group, says this exuberance is overshadowing a troublesome dynamic lurking under the market's surface - one that's threatening to erase 10 years of progress and prosperity.

The "critical variable" to which he's referring is consumer confidence, which he says has shown signs of serious weakness of late. And what makes the declining-confidence situation even more puzzling - and potentially damaging - is that it's occurring at a time when market conditions appear to be just fine.

In case you don't feel like taking Ramsey's word for it, consider the following:

• A gauge of how consumers view their "Present Situation" fell in March by the most since 2008.
• Leuthold's quantitative analysts find that the Present Situation reading is the indicator most closely linked to future stock market performance.
• When the Present Situation index is in a downtrend, like it is now, monetary easing from the Federal Reserve has basically no impact on stock performance. That stands in contrast to the idea that a more accommodative Fed is bullish for equities.

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The chart below shows this dynamic in action. It shows that annualized S&P 500 returns have been firmly negative during periods where the President Situation confidence index has been below its moving average. As you can see, the recent drop puts it firmly in dicey territory.

Leuthold Group

While Ramsey doesn't see this vulnerability in consumer confidence rearing its angry head right this moment, he warns that any further weakness could be catastrophic, especially if it's swift and sharp.

So what's ultimately at stake? An entire 10-year bull market of gains, according to Ramsey.

"After years of overdoing it, policymakers should now be careful not to overdo it," he said in a recent client note. "Confidence is fragile enough that excessive dovishness might actually be harmful."

He continued: "If confidence erodes for even a few more months, we believe the entire US recovery from mid-2009 will come to an end."

In terms of what could cause such a sudden decline in confidence, Ramsey says it could be moderate equity-market weakness. This may seem counterintuitive, since he also expects flagging confidence to drag stocks lower. But in the end, it's a circular situation, with the two forces working in tandem to create a vicious downward cycle.

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"There's no denying that the stock market's trend has, itself, become a critical 'fundamental' now that confidence has suffered an initial jolt," Ramsey said. "Even a mild S&P 500 setback to, perhaps the 2,750 threshold, could conceivably drive consumer and investor confidence below the point of no return."

For context, 2,750 is just 5% below current levels. That's dangerously close.

With all of that established, it must be reiterated that Ramsey and his Leuthold colleagues aren't expecting a full reversal of the decadelong bull market in the immediate term. They recognize that the market's rally of its December lows is still a force to be reckoned with, and they don't want to continue paying up for downside hedges.

For that reason, Leuthold actually reduced hedges in recent weeks, and has boosted its allocation to equities by 6% in recent months.

But don't let that fool you into thinking Ramsey & Co. are calling the all-clear. They're still keenly focused on deteriorating confidence.

"Historical retracements any larger than last month's 12-point move have proven irreversible, with US recessions and bear markets ensuing immediately (if not already underway)," Ramsey said.