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2022 has started as a challenging year for investors. The first week of the new year began with a large crash in the bond market, followed by a relatively large stock correction. While nobody can predict large crashes with complete certainty, a growing number of signals and patterns suggest that the decline in stocks is only beginning. Fundamentally speaking, there is immense mounting evidence that the global economy is slowing at a rapid pace. From a technical standpoint, key indices such as the Nasdaq 100 and Russell 2000 have crashed below crucial support levels, indicating the potential for widespread capitulation.
Leverage levels in the stock market corporate debt levels are excessively high today. Thus, investors (both institutional and retail) may be forced to sell positions to maintain liquidity. Fortunately, I believe today’s unique market dynamics give investors some uncommon protection areas against the storm. Most notably, hedges against inflation are resilient to declines in economic growth. That said, it appears to be an excellent time to raise cash reserves to look for healthier real discount opportunities in the future.
It is likely that many investors are startled by declines and may want to avoid confronting those facts and figures which suggest further downside. However, beliefs in “always buy the dip,” “The Fed will always bail us out,” or “Bonds will always hedge my stocks” may prove to be deadly given the Federal Reserve is likely incapable of supplying further liquidity to the market. For similar reasons, it may take decades for the potential losses to be recouped in real terms. Accordingly, I would like to give a detailed overview of the core reasons why I believe the S&P 500, Dow Jones, and Nasdaq 100 are likely headed for 50%+ declines.
Valuations Are At Historically Bearish Levels
By most measures, stock market valuations have been above the long-term norm since 2014. Of course, investors that have avoided the market since then have missed out on the tremendous rally. In my view, the core reason for the growth in the U.S stock market over the past seven years has been the impact of ultra-low interest rates and liquidity creation from the Federal Reserve. Low-interest rates directly push up all companies’ fair discounted cash flow, particularly growth stocks, since they have more significant future cash-flow growth. Low rates have also allowed companies to easily take on debt to pursue development, cheaply refinance higher-rate debt, and in many cases, borrow money to repurchase equity shares (thereby creating somewhat artificial EPS growth).
The “easy money” era, which has existed since 2009, has created many dislocations in the market and within corporate balance sheets. Given the sharp rise in interest rates following the forty-year high inflation rate, it appears that this era is officially ending. As this occurs, I suspect many of these dislocations will be brought back to normality, likely forcing bond and stock valuations significantly lower. Indeed, over a century of S&P 500 valuations have, in general, been inversely correlated to the inflation rate.
While the inverse relationship is far from robust, we can see a general pattern. Inflation was high following WW1, and stock market valuations were depressed. This environment changed by the 1920s when inflation slowed a bit and valuations surged on the Fed’s prolonged reluctance to raise interest rates. The bubble popped shortly after their belated decision to raise rates. After the Great Depression, inflation rose during WW2, and the S&P 500’s CAPE fell to <12X for around a decade. From roughly 1950 to 1970, inflation returned to ultra-low levels post-war, allowing valuations to rise again. Then, in the mid-70s, inflation began to get out of control, causing the Fed to hike rates and causing the S&P 500’s CAPE to fall back to ultra-low levels.
The post-1970’s changes are more apparent in higher quality data such as the sum of the stock market capitalization and total U.S debt (public and private) compared to GDP. This figure fell as inflation and rates rose in the 1970s to early ’80s and has risen dramatically during the subsequent “Great Moderation”
the total stock and bond market value compared to GDP is the most accurate overall measure of valuations. It is somewhat comparable to a company’s “enterprise value to operating income” metric, which leverage cannot obfuscate. Essentially, the total gross domestic product (or total income) must support the financial markets through interest, dividends, and similar payments to asset owners. When the total value of assets is extremely high compared to the GDP, more money flows toward asset owners and away from workers. This can be seen directly through the share labor-to-capital compensation ratio, which has generally shifted from labor toward capital (i.e., asset owners) since the 1970s.
When rates are below inflation or are at least declining, asset prices can easily rise without forcing more money to flow away from labor toward capital (asset owners). However, when rates rise, a significant portion of the GDP shouldflow toward capital (asset owners) as companies, governments, and people pay higher interest rates. Of course, the labor share of GDP is already at extreme lows and likely cannot go lower, particularly considering the growing labor shortage. Thus, if rates rise, asset prices must decline to keep a constant level of capital/labor share of GDP.
While this may sound complicated, it is akin to saying that home prices rise when mortgage rates drop to the degree that monthly payments remain flat. Similarly, home prices must decline as mortgage rates rise to keep monthly payments constant. Real interest rates will need to increase as we enter another long-term period of goods and labor shortages. I believe this shift is already pushing asset prices down through these “labor vs. capital” dynamics.
Why A Recovery Could Take Decades
Of course, this is a very long-termsituation based on long-term cycles within the monetary and financial markets, so short-term factors. This long-term pattern implies that, when asset prices decline, they will likely stay depressed for decades as it may not cause a decrease in inflation large enough to allow for stimulative monetary or fiscal policies. For example, if it were not for the Federal Reserve’s immense Q.E in 2008 and 2020, stocks would not be as high as they are today. Many foreign equity indices have generally had far less monetary stimulus since 2008 are still trading near the same levels they were fourteen years ago. This issue is particularly true with emerging markets struggling with high inflation and thus having higher interest rates.
Considering the U.S is very likely in a persistent supply-driven inflationary era, the Federal Reserve will not likely support the market if it crashes. A similar example was after the Great Depression when it took the stock market over two decades for its inflation-adjusted price to return to pre-crash levels. Honestly, looking at valuations, debt, and many other trends, I believe we are in a similar environment to 1929 today, so if the market crashes, investors should not expect to recoup their losses as quickly as they have over recent decades.
Short-Term Signals Of An Impending Crash
The evidence above demonstrates the high probability of poor stock and bond market returns over the coming decade. While the inflation spike has increased this probability, it is still a long-term outlook. Without more specific short-term signals, it would be possible for stocks to rise higher. Admittedly, these less-lengthy patterns are not as reliable, and, in my opinion, there have been growing signals of a stock market crash since last summer. However, they have risen to such extreme levels that it appears highly unlikely to me that stocks rise back to and sustain new all-time highs.
Firstly, U.S margin debt (leveraged stock market positions) is currently at nearly $1T, while AAII’s survey ofaverage investors shows a cash-allocation level is 14%.
Historically, high margin debt and low cash allocations are a bearish signal, as last seen in late 2017. Cash allocationswere at similar extreme low levels in early 2000 before the Nasdaq 100’s roughly 90% crash. Cash levels were higher before the 2008 crash, and valuations were approximately average while margin debt levels heightened. Today, we have low cash allocations, high margin debt, and high valuations (particularly after accounting for total debt). As such, if stocks or bonds decline, then many investors will likely be forced to sell positions to raise cash to meet margin requirements. In many cases, such situations can create catastrophic cascading declines.
Another major factor that has benefited the stock market since 2020 has been the tremendous influx of new retail investing activity. In fact, mass-closures of businesses and stimulus checks may have directly promoted stock prices as it resulted in people having more savings than could be put in the stock market. Indeed, the percentage of total household wealth invested in the stock market has surged to an all-time high of ~41% since 2020. However, the savings rate is now below pre-COVID levels as many people struggle with negative real wage growth, forcing them to reduce spending. See below:
Real wages are falling, and savings rates are plummeting, meaning that many people do not have free savings to be put into stocks. Combined with low investor allocations, high margin debt levels, record credit card debt, Fed tapering, and rapidly rising short-term rates, there is essentially no source of domestic liquidity that can go into stocks. Indeed, with many investors needing to pay taxes on last year’s tremendous gains, many will need to sell assets to raise cash.
Of course, we also have the general trend of abysmal consumer confidence and declining business confidence. Consumer confidence is around Great Recession levels, likely due to falling real wages and an admittedly strange.
