Worse Than the Dot-Com Crash? Why Michael Burry Thinks the Market Is in Deep Trouble

The dot-com crash is known for being one of the worst stock market collapses in recent memory. It came at a time when the internet was in its infancy, and many stocks were surging in value simply due to hype.

Investors sometimes compare the euphoria around artificial intelligence (AI) stocks today to how the market was back then. The S&P 500 (SNPINDEX: ^GSPC) is coming off a third straight year of double-digit percentage gains, which may be worrying investors that a crash or a serious correction is inevitable.

However, unlike in the dot-com bubble where many risky internet stocks with no revenue or earnings were soaring, the companies that have been taking off in recent years are making real profits and have strong financial results, justifying their valuations. Nvidia, for instance, has become a growth machine. While its valuation looks rich with a market cap of about $4.6 trillion, its forward price-to-earnings (P/E) ratio (which is based on analyst estimates), is less than 25 and might not look all that expensive in light of its growth potential.

But Michael Burry, who founded Scion Asset Management and is known for predicting the housing crash nearly two decades ago, believes that valuations are extremely high and inflated across the board, and that there could be a significant crash coming. And here's why he thinks it may even be worse than the dot-com crash.

Image source: Getty Images.

Burry believes passive investing could make things worse

A big reason Burry thinks a crash this time around could be worse is because of the growing popularity of passive investing. As opposed to people investing in specific stocks and only certain ones being overvalued, a much wider array of stocks may be due for a decline, rather than a specific group as in the dot-com crash.

"In the United States, I think when the market goes down, it's not like in 2000, where there was a bunch of stocks that were being ignored and they'll come up even if the Nasdaq crashes," he said. "Now, I think the whole thing's just going to come down."

With many exchange-traded funds and index funds holding hundreds of stocks and all rising and falling together, there could very well be devastating results in a market crash. Nvidia and other top tech stocks account for a large portion of the investment funds and if they fall, they could bring down many other stocks along the way.

Are Burry's claims valid?

Burry suggests that it would be extremely difficult to protect yourself in any crash. The reality is that in market crashes, it's generally hard to protect yourself from incurring any losses to begin with. It's an inevitable risk that investors always have to consider.

In a crash, investors may be inclined to pull money out of all of their investments, not only money that's invested in ETFs and other passive investments. It's that widespread panic that can send the market as a whole into a tailspin.

But trying to time the market is by no means a better strategy. Even if you may be worried about inflated valuations and a possible bubble in the market today, simply selling all your investments and converting your money into cash may not be the best solution. A crash could be months or even years away from happening. Trying to time it is a risky move as it could leave you on the sidelines, potentially watching as stocks continue to rise higher.

How investors can reduce some of their risk

There are undoubtedly many very expensive stocks to avoid in the markets today, but that doesn't mean there's no hope for investors and that the only solution is to get out of stocks. By focusing on modestly valued stocks, and ones that have low beta values and don't move in unison with the overall market, those are examples of a couple of ways investors can reduce their overall risk.

Although almost all stocks may fall in value in a market correction or crash, that doesn't mean they will all fall to the same degree. Investors can and should always protect their portfolios by considering not only a company's fundamentals and growth prospects, but also its valuation.

While Burry may be right to raise flags given how hot the stock market has been in recent years, that doesn't mean there aren't many safe investments out there today, especially when looking at the long run.

David Jagielski, CPA has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.