There is a great deal of excitement in the markets. The S&P 500, DJIA, and Nasdaq continue to break all time highs. But I am very concerned. There are a number of factors which driving the probability of a crash higher. Furthermore, the probability that the crash will be deep is being driven higher as well.
One thing that does not matter is the value of the markets themselves. I will not say that the markets reaching new highs is reason for concern. We should not be looking at the price history of the markets, but rather than fundamentals which generally drive the markets in one direction or the other.
First, consider the aggregate P/E of the S&P 500. As of 2/15/2017, the aggregate P/E for the S&P 500 was 26.37. The median and mean aggregate P/E is 14.65 and 15.64 respectively. One of the reasons why the aggregate P/E is so high is that earnings have been declining while the stocks in the S&P 500 have been increasing in price. In 2015, earnings declined by 15%. As of September, earnings growth in 2016 was also negative. While the markets are forward looking, the difference is a bit extreme.
Market Cap to GDP
This is one of Warren Buffett’s preferred measures of market health. The measure is simply the total market capitalization of a given market divided by GDP. There are a few markets from which one can choose. Buffett uses Corporate Equities: Liability. Advisor Perspectives also includes an alternative measure: the Wilshire 5000 index. By either measure, stocks are hovering in an area which surpasses the value before the 2007 – 2008 crash and was last surpassed before the dot com bubble collapsed.
So what has been driving the markets higher? To an extent, it has been the financial sector. I am not going to go into too much detail, since I have a full article on the topic, but the banks constitute a large component of the recent boom in the markets. However, the growth in bank stocks has been fueled by market exuberance. This feedback mechanism is a double edged sword. While it has been driving the market higher, if things turn south, it increases the chances of a deeper correction/crash.
I already mentioned corporate earnings. But there are multiple other economic indicators which are troubling. Taking into account official inflation numbers, real wage growth is negative. Even with the supposedly low unemployment rate, if the quality of jobs is poor, then we’re not really even close to full employment. This is doubly true when one takes into account the low labor force participation rate, which is seeing growth largely among seniors and is exceptionally weak among young adults.
Geoeconomic & Geopolitical Uncertainty
The state of the global economy is sitting at a precipice. Much of the direction of the global economy, and as a result, the health of the US economy, will depend on the actions taken by the current administration. President Trump has threatened war with a number of nations, has pissed off key allies, and has made it more difficult to conduct negotiations.
He has threatened to invade Mexico. Just as bad, he has threatened to engage in a trade war with Mexico. The Republicans have picked up on that idea and have been working on a tariff policy that would increase the price of imports from any part of the world. This kind of policy is in no way novel. FDR tried this protectionist agenda and it took a recession and helped turn it into the Great Depression.
Furthermore, President Trump has attacked the “One China” policy. Honestly, this is acceptable to me. I don’t think we should respect mainland China over Taiwan. However, Trump has offered nothing to calm mainland China’s, or any other nation’s, concerns. Instead of being a solid negotiator, he simply wacks nations with a stick.
I forgot to include a section on debt when I first wrote this article. There are multiple forms of debt which present concerns, including corporate leverage, margin use by investors, and consumer credit.
Eric Parnell wrote an article on Seeking Alpha that explains the issue of corporate leverage fairly well. One of the driving forces behind the rise in corporate leverage has been stock buybacks, which have been used to drive share prices higher. Essentially, corporations have been using increasing amounts of leverage in order to inflate stock prices. This is one of the reasons why the markets appear to be doing so well.
One of the reasons I decided to add a section on debt was because of the article I saw by John Rubino. As Rubino points out, margin debt has been increasing since 2009, and is now above the levels seen prior to the 2000 and 2007 stock market crashes. Prior to the 07 crash, the NYSE margin debt was roughly equal to the value of the S&P 500; the two values have been dancing around one another for the last few years.
Consumer credit of course is going to grow with respect to inflation and growth of the economy, so before we can address changes in consumer credit trends, we have to adjust for those factors. Therefore instead of looking at consumer credit itself, it is probably better to look at consumer credit to GDP. The graph suggests that consumer credit as a percentage of GDP has been growing for decades.
That in and of itself is not a good thing. However, let us suppose that an intrinsic growth in consumer debt to GDP was simply a product of a maturing economy. The trend appears to be fairly linear, so we can shift the data by finding the best fit line, and subtracting the current value from the linear regression value. For Q3 of 2016, consumer credit to GDP was 1.6 percentage points above the baseline. The maximum percentage points above the baseline was 1.7 and that occurred in the early 2000s.
See spreadsheet for more detail.
Expectation vs Reality
This factor has a significant impact on the potential depth of the correction/crash. Investors are familiar with the phrase “buy the rumor; sell the news.” Even when expectations meet reality, there can be significant swings in the market, as people engage in profit taking and loss cutting measures.
When expectations do not meet reality, we can see much larger swings. Right now the expectation is that the economy is and will be healthy in the near future. The VIX, which in a way measures market “fear” is near all time lows, and has only recently started inching higher. Meanwhile, all of the factors that I have mentioned above indicate a much riskier market than which is perceived by the average investor.
So long as the markets and the economy remain decoupled, a condition which is in large part due to government and central bank manipulation, the rally could potentially continue. However, once there is a re-coupling, the market does not stand much of a chance.
I decided to include this article based on a recent discussion I had on Seeking Alpha. Those of us who have been warning about the risks in the market have been called “naysayers” repeatedly. It’s true that so far the market has not crashed or seen a large correction, and those who have doubled down in the markets have been doing quite well for themselves. However, this actually does not mean that we are wrong. It is a matter of probability. Just because there is a high probability of a correction does not mean that it will happen immediately. This is why it is so important to understand probability theory when working with the markets.