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Could the ASX crash below 4,000 points?

As the most widely used benchmark for Australian equity investors the S&P/ASX 200’s (Index: ^AXJO) (ASX: XJO) crash under the 5,000 point level means many investors will nervously wonder how much further it could fall.

To hit the 4,000 point level would require another 20% average fall in the value of the index, with the major weightings like financials and resources likely to lead the way.

Given that financials account for nearly half of the index weighting and the big 4 banks like Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB), and Westpac Banking Corp (ASX: WBC) more than a quarter, then a fall to 4,000 points would require a significant fall in their market values.

The other excess fallers would likely be energy and mining stocks like Rio Tinto Limited (ASX: RIO) and Woodside Petroleum Limited (ASX: WPL) as commodity prices continue to crumble.

One potential consequence of the commodity crash is that mining and energy companies go bankrupt weighed down by debt after borrowing heavily to invest in now unviable projects, while being unable to turn an operating profit on low commodity prices.

One warning sign is that last week the Pilbara-based Nullagine iron ore mine jointly operated by BC Iron Limited (ASX: BCI) and Fortescue Metals Group Limited (ASX: FMG) announced it was to suspend operations due to the falling iron ore price.

This effect leads to rising Australian unemployment and a rush to the exits by global investors in debt-linked or equity-based commodity assets, initially in the junk bond markets where resource companies often issue debt to fund investment projects.

A second warning sign is that last week a major US high-yield junk bond fund managed by Third Avenue Management collapsed as investors all ran for the exits at once in an attempt to protect their capital.

A third warning sign is that last April Fortescue Metals Group was forced to raise US$2.3 billion of debt at a coupon of 9.75% as US capital markets demanded more return for the elevated risks of lending to indebted Australian resource companies. This may give Fortescue more breathing room for now, but can it keep kicking the can down the road if iron ore prices trend lower?

As the recent anxiety in high-yield bond markets grows the flight to safety accelerates as emerging market economies like China, Russia and Brazil slump as investors abandon them, while commodity-linked economies like Australia and Canada head into recession on commodity price weakness and rising unemployment.

The shock of the GFC sent many Western households on a deleverage cycle from 2009 onwards, but not in Australia where household debt continues to rise to record levels and in turn becomes more leveraged to the risk of falling asset prices.

This then leaves a potential repeat scenario of 2008/09 where credit markets dry up as large commercial lenders worry over the creditworthiness of multinational peers and an Australian economy tipped into recession by the commodity crash lurches into GFC-style trouble as record high household debt levels lead to debt defaults, a credit bust, and soaring unemployment.

This time though China is unable to ride to the rescue and this scenario could easily see the kind of sell off in equities to take the S&P/ASX 200 20% lower or more from here and under 4000 points. Ouch!

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Motley Fool contributor Tom Richardson has no position in any stocks mentioned.

You can find Tom on Twitter @tommyr345

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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