Friday, July 8, 2016

Predicting a Crash: Part Four

So far in our investigation, we've looked at the existing fundamental condition of the global economy to support the proposition that a crash is coming. Debt levels have continued to rise since the financial crisis in 2008, and companies and households continue to increase their leverage despite mini-crashes in August of 2015 and January of 2016. The declining health of corporate and governmental balance sheets has endangered the survivability of many national stock markets which are faced with the risk of crisis similar to the Greek debt crisis that happened a couple of years ago. These debt conditions are allowed to prevail because of the loose behavior of the world's central banks, namely the Federal Reserve, the European Central Bank, and the Bank of Japan. Cheap credit has encouraged a growth in business loans, mortgages, auto loans, and credit card use that has surpassed the levels seen in the years leading up to the financial crisis. The conditions just described are not necessarily indicative of a global crisis, but if a degrading fundamental position is paired with an overvalued asset market, a dangerous game of musical chairs ensues. In closing this investigation, we will look at and analyze some of the trends in stock evaluations that have developed in the seven-year bull market that followed the worst recession since the Great Depression. With any luck, the bystanding investor can use this investigation to develop an exit strategy before the storm hits.


Stocks act as the barometer of the economy measuring the fluctuations of business strength and individual sentiment on a daily, weekly, and yearly basis. Stock market patterns always react to a brewing recession and often lead economic downturns that are unexpected. One measure of overvaluation, and perhaps the most popular is the price-to-earnings ratio of the S&P 500 over time. The chart above shows the historical data for this measure. Upon observation one notices many peaks which are followed by consolidation periods that eventually lead to another peak. Another interesting observation is that overvaluation was not typically a problem until after the 1980's. While there is a smaller peak around the 1929 mark, the P/E valuation measure would have said very little about the market crash that led to the Great Depression. However, major peaks before market downturns in 2000, 2003, and 2009 have proven to be very accurate in describing overvaluation. After P/E ratings reached over 70 in 2009, they settled in the mid- to low-teens. From 2012 to now, S&P 500 growth has lead to a 63 percent increase in the corresponding P/E measure. These levels compare to those seen just before the tech bubble popped in 2000. So bubble territory is not out of the question. The truth is earnings have not grown as robustly as they were supposed to coming out of the recession. A slowdown in European growth and recent stagnation in the Chinese economy has jeopardized the expansion of many multinational firms that aggressively expanded after the financial crash even though the Federal Reserve support them with low-interest rates. In conjunction with encouraging business investment, the Fed also set out to bolster equity investment by dropping bond yields lower forcing money managers to look for alternate forms of high yield.

With a low-interest rate and low bond yields, investors can expect cheaper debt financing and higher earnings for the equities in which they invest. In any investing situation, such conditions allow for larger dividends and stock price appreciation. In the end, stock demand increases and the cycle feeds back into itself. Bubbles form in these conditions when market psychology gets overly positive and the crowd maintains a laser sharp focus on expansion. This kind of over-zealous attitude was (and still is) consistently encouraged by loose monetary policy and their own analysis which replicated the optimism that fueled the rise in stock prices. This mismanagement and dovish approach to recovery have resulted in the current trend of overvaluation, and any attitude or policy change to the contrary could knock down the house of cards that has been built. Central banks and other monetary institutions have a responsibility to summarize the current state of the economy, not push an agenda of stock market expansion. While investors will trade news events positively, they will also correctly price the current economic condition whether it is bad or good. In the end, unhealthy, unstable, or weak fundamental positions will be realized by the general investing public, and when this occurs, traders usually find things worse than what they expected.

Another interesting measure of overvaluation to observe is the growth rate of the S&P 500 index against the growth rate of the U.S. economy. The idea is to look for periods where the quarterly growth in the stock market superseded the economy it is supposed to represent. In the chart above, one can observe similarities in the years preceding major market crashes, Just before the mysterious 1987 crash, stock growth peaked well above GDP growth and fell successively until it reached almost zero at the turn of the decade. The introduction of the internet and the popularization of that mass communications technology caused great speculation to inflate the stocks of companies that listed on the market. Actual economic prosperity failed to reflect investment growth and the bubble popped. Stock market quarterly growth once again peaked just before the 2008 crisis. Notice that economic expansion seemed to match those levels hinting that there might not have been overvaluation. This may be true as the bubble that popped was in the housing market. Nevertheless, it was clear that the stock market had warmed up quickly in the quarters before the financial crisis. Following the crash, S&P 500 and U.S. GDP growth both tanked and soon recovered. The disparity between stock market growth and the growth of the economy soon formed and has remained through 2015. So if a crisis is brewing, when will it occur? The past three markers did not last very long which suggests it could be sooner than you think.

We've reached our final argument, and we must come to a conclusion about whether or not an asset bubble has formed on the stock market. On this article's day of publication, the Dow Jone Industrial Average grew to its highest level over 18,000 on news of an exceptionally strong jobs report. The appreciation appears real, supported by robust job market improvement because of the Federal Reserve's patient hand. All the while. FOMC governors and Chairwoman Janet Yellen are huddled, preparing a strategy for gradual monetary tightening. Knowing this could be the demise of the seven-year bull market, investors should heed the Fed's words and thoroughly investigated every Fed publication in the second half of 2016. The cues of the beginning of the next crisis will come from these prophetic words, and they are not to be underestimated. As long as companies are allowed to grow freely in a low-interest rate environment, speculation will be justified. But, demand for equities and the higher amounts of risk will soon dry up endangering accessibility to corporate finance. When this time comes, a crisis will be upon us, and views in hindsight will be the only perspectives left as stocks sell-off once again.

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