The prospects of an especially severe stock market decline are far greater than widely perceived. There is a strong possibility of the most severe decline in over a century transpiring. In fact, a decline on the magnitude of the bear market in stocks after the 1929 peak, where the market lost over three fourths of its value and decimated the savings of many investors, is within the realm of possibility. Such a claim isn’t emotional fear mongering. Nor is it based on an end-of-the-world type scenario. Instead, there is a very logical case that can be made for why investors should be especially defensive right now, and seriously question the oft repeated buy-and-hold advice from pundits that is so prevalent around stock market tops.
Stock Market Bubbles
The word bubble gets thrown around a lot. It’s often used imprecisely. For example, in 2000 there was not a bubble in the general stock market, which peak to trough, would lose about half of its value. But there was a bubble in tech stocks, where the Nasdaq would lose over three-fourths of its value. Presently, there is not a bubble in the majority of foreign or even U.S. stocks. However, it is important to point out that doesn’t make them immune to big losses, along the lines of how the S&P 500 lost about half its value in the last two bear markets. Stock diversification delivers little protection from the ravages of a big stock market decline, since stocks tend to be correlated to one another. In fact, many stocks are already in a bear market, with over 20 percent declines.
Yet, when bubbles pop they tend more towards the three-quarters type losses. And there likely is a bubble in the majority of investor money allocated to U.S. stocks. That’s because money isn’t allocated evenly to stocks. The biggest and best performing stocks get more investor money. And this is where current risk is concentrated in the U.S. stock market. This is unlike the last bear market, where risk was concentrated around subprime real estate related investments and before that around technology stocks. And if today’s frothy stocks decline in bubble fashion, they will take the capitalization weighted S&P 500 index, related index and ETF products, and very many actively-managed or passively-indexed investor portfolios, down to depths most folks can’t fathom.
The New Can’t Miss Investments
FANG, NOSH, FANTAsy, and other acronyms have been created for the very small handful of very large stocks representing a big share of both stock market gains and the capitalization weighted stock market. Facebook (O:FB), Amazon (O:AMZN), Netflix (O:NFLX), Alphabet or Google (O:GOOGL), Nike (N:NKE), O'Reilly (O:ORLY), Starbucks (O:SBUX) and Home Depot (N:HD), Priceline (O:PCLN), eBay (O:EBAY), Microsoft (O:MSFT), Salesforce (N:CRM), Tesla (O:TSLA), and before its recent fall from grace Apple (O:AAPL), are all stocks on the short list of performance leaders. Even investors who don’t own these stocks directly often own them indirectly in the form of actively managed investment products, exchange traded funds and index funds that are typically capitalization weighted.
We’ve seen this story before, where a handful of stocks dominate the market and lead it higher, as their valuations become increasingly irrational. In the tech bubble of 2000, the 100 largest Nasdaq stocks led the market higher and then led the move down. The 1973, 1974 bear market saw the broad market lose about half its value after a relatively short list of stocks—the so-called Nifty Fifty—that were a sure thing of America’s best companies, turned out to not be such a sure thing. Some of the Nifty Fifty would fall substantially more than fifty percent, despite being considered the highest quality stocks of their times. But the lesson of can’t miss investments in the stock market is that ultimately valuations matter, and no investment is can’t miss, no matter how good the company.
Borrowing Against the Future
This has been a subpar economic recovery, with poor workforce participation, household income and productivity growth. But the stock market has soared, and that’s a problem. Asset prices becoming delinked from their fundamentals is a core characteristic of a bubble that makes that asset prone to massive declines, when financial reality reasserts itself. Two big drivers of stock market performance in the absence of strong economic growth driving sales and operating profits higher, have been the aforementioned trend of a few giant, high-flying stocks pulling the entire cap-weighted market performance higher, largely via margin expansion, and also the trend among a broader universe of U.S. stocks of financial engineering.
A key aspect of financial engineering that has driven the stock market higher is the borrowing of money by companies to buyback their own shares. This process can create earnings growth where no sales growth exists. Simply by reducing the share count, a company increases its earnings-per-share (EPS). But there is no free lunch and corporate debt levels for many publically traded U.S. companies are at the highest levels ever and there has been a significant deterioration in corporate balance sheets. On the other hand, stocks with the heaviest buyback activities have outperformed the rest of the market. With recent troubles in credit markets, impacting borrowing costs, this trend is showing signs of having peaked. And a stock that has driven its EPS and price higher primarily by borrowing money is a strong candidate for being a bubble stock.
A Long Way Down
Financial engineering has done more than increase corporate debt. Wage suppression, cost controls and other measures drove up corporate profitability to a greater than normal share of the U.S. economy. But over time corporate profits are mean reverting. Over time the stock market tends to grow with, rather than in excess of the economy. Over the long sweep of history, economic growth in developed economies evens out.
Methods for valuing the stock market that are actually predictive of its future performance tend to function based on these variables, whether it is the Q Ratio (measures the total value of the stock market divided by the replacement value of its companies), a simple reversion calculation to a long-term stock market trend line, or a methodology, like the Shiller PE or CAPE (divides the price of companies in the stock market by inflation-adjusted earnings for the last 10 years), or other related mean-reverting methodologies based on inputs like forward operating earnings, profit margins, dividends or revenue.
What these metrics show in aggregate is that the current stock market peak is in the neighborhood of the 1929 peak, but below the 2000 peak. Getting back to a fairly valued stock market implies a decline of about half. But, although it wasn’t the case after the 2000 or the 2007 tops, declines historically often overshoot fair value. A decline in the S&P 500 of true bubble bursting proportions and well over half, is very possible based on both history and current conditions, including the current risks around market liquidity evaporating in a big down move.
Furthermore, central bankers have proven that debt can drive economic growth and stock market returns, however unsustainable such returns turn out. But at this point what is there left to inflate? There may not be any better sign of the current debt cycle coming to an end, than the negative interest rates popping up around the globe. This time there is unlikely to be a debt binge around residential real estate in the developed world or more recently around real estate and infrastructure in China, to pull things out.
The Other Side of the Coin
You would think we might have learned our lesson about trying to borrow our way to prosperity from the subprime crisis that led to the previous bear market. Of course areas where that subprime real estate debt were concentrated, suffered enormous losses. Now, we’ve got more debt on corporate balance sheets of S&P 500 companies, as well as over a trillion in auto loan and also student loan debt that looks increasingly risky.
And that’s not even touching on the mountain of debt in China, where economic troubles have rippled into commodity-dependent emerging markets and are now being felt in a debt-sensitive U.S. energy sector that was responsible for many of the few good paying jobs created in this recovery. It’s much easier to imagine a scenario, where central banks are not able to significantly support the economy by encouraging more debt formation, than one where they are able, if the U.S. consumer falters.
Then again, there are no certainties in the stock market, and maybe the consumer weathers the current storm, despite the present earnings and manufacturing recessions. But valuation and macro-economic concerns, have been enough for my firm to reduce equity allocations. Furthermore, signs of debt stress in credit markets were enough for us to still further lower stock allocations, prior to the current downtrend.
Technically, the current stock market looks awfully similar to the last market top and technical weakness has triggered risk measures in many existing positions, still further lowering our stock exposure. In terms of the stocks we’ve picked for portfolios, we’ve focused on what we consider truly quality stocks. Yet, it’s not uncommon for our investors to presently have less than ten percent overall stock exposure in an actively managed account.
Now, all that could change if conditions change. We evaluate risks and opportunities, but we don’t try to predict markets. We simply react to key and ever-changing indicators. But a lot of things would need to improve for us to meaningfully increase our risk profile around stocks. Right now there is simply too much in the way of risks around a once-in-a-lifetime, immense stock market loss, for it to make any sense to have sizeable U.S. stock market exposure for a long-term investor.
Getting defensive here is the easier decision. Figuring out when to increase stock exposure again, as well as in the event of a decline, how low is low enough to buy, is likely to be the bigger investment challenge. Then there is the other side of the coin. If the worst happens, it will create the kind of once-in-a-lifetime buying opportunity that delivers substantial outperformance for those who successfully navigate some very choppy market waters.