Will the S&P Fall to 400?

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 |  Includes: SPY
by: Balance Junkie

The future is an opaque mirror. Anyone who tries to look into it sees nothing but the dim outlines of an old and worried face.

~Jim Bishop

Most people would agree that it’s pure folly to try to predict the future – especially that of the financial markets. And yet we don’t want to invest blindly either. We need to have at least some concept of where we’re at in the economic and market cycle, as well as the future prospects and valuation metrics for any company we may choose to buy.

Every investment decision is a bet on the direction of a given company, sector, or index. I know some passive investors out there don’t think they’re making market calls, but buying any financial instrument is a wager it will be worth more by the time we sell it. Otherwise, why buy it in the first place?

So we’re left with thousands of market hypotheses and predictions to sort through each and every day. Some prognosticators carry more sway than others. If one of them happens to be correct more than twice in a row, they can quickly earn guru status among investors. Some gain an audience by making extreme calls on the market.

Today we’ll take a look at a couple of calls for the S&P 500 to fall to 400 from its current perch around 1300 – a pretty extreme drop by any measure.

S&P 400: Russell Napier’s View

Russell Napier is a market historian who recently did an interview with John Authers (FT columnist and author of The Fearful Rise of Markets) in which he reiterated his view that unprecedented central bank balance sheet expansion has failed to stimulate Western economies to the point where they can function on their own. Rather, he believes the massive monetary stimulus has led to overheated economies and inflation in the emerging markets (EM).

Mr. Napier believes EM countries will tighten monetary policy in order to curb inflation. This may include allowing their currencies to appreciate. Mr. Napier thinks this will lead to lower demand for U.S. Treasuries and, as a result, higher Treasury yields.

This tightening of global liquidity will lead to “The Great Reset” in which real U.S. bond yields rise and a deflationary bust causes the S&P 500 index to plummet. Mr. Napier sees the S&P bottom at around 400, which would bring it to a very compelling valuation according to the Shiller PE. He believes this will represent a generational buying opportunity.

S&P 400: Albert Edwards’ View

Albert Edwards of Société Générale also sees the S&P 500 falling to 400. While many strategists think inflation and rising bond yields are a given as the Fed ends its QE2 program in a few weeks, Mr. Edwards sees bond yields falling rather than rising. He thinks that risk assets will be hit hard as global liquidity tightens and he sees stock markets dropping precipitously as a deflationary bust takes hold.

While Mr. Edwards concedes that the global epidemic of balance sheet debauchery will eventually lead to double digit inflation and interest rates, he sees lower interest rates first. Rates will initially fall on economic weakness, and Napier’s Great Reset of Treasury yields (higher) will only come “after a frenzied orgy of balance sheet debauchment (both Fed and Federal) which will make events over the last three years look like an afternoon tea-party with the Vestal Virgins.”

Putting Predictions in Perspective

A little quick math tells us that a fall from 1300 to 400 for the S&P 500 is a 70% drop. Your talking about real money now. That kind of drop would put a serious ding in retirement plans around the globe, as well as doing some significant damage to the insurance companies and pension funds that rely on historic market returns to run their businesses and fund payouts to policyholders and pensioners.

At this point, a 70% drop in the S&P 500 doesn’t seem all that likely. After all, the balance sheet problems Edwards and Napier are worried about have been with us for a long time now and the S&P 500 has doubled over the past 2 years.

But . . .

That double came off a low that represented a 57% drop from the previous high. If you conducted a survey in October of 2007, many people would have said such a drop was impossible. I’d wager that a similar majority would have felt that a double from those lows in just 2 years was equally unlikely.

Given the 57% drop we all lived through just a couple of years ago, you would have to admit that a 70% drop, especially given the global balance sheet backdrop, is not so crazy. On the other hand, governments and central banks have been able to support asset markets for some time now, and that could continue. Does anyone doubt that QE3 will follow QE2 at the first whiff of weaker economic data? How much longer can we kick that can down the road?

What Is the Probability of a 70% Drop?

The fact that Edwards and Napier could arrive at the same (albeit extremely low) target for the S&P 500 and still come up with rather divergent views of the bond market speaks to the complexity of the current market environment and the importance of timing. Both see inflation and much higher interest rates in the future. But when? In 6 months or 6 years or some other time frame?

Other strategists don’t see any form of deflationary bust coming down the road. Rather, they believe the S&P 500 has embarked on a bull market run that has a lot more legs. Who do you believe?

I guess the point is that none of us knows for sure what will happen, but all of us have to make some kind of probability call in order to invest our money. Your call will likely be based on your personal income and balance sheet combined with the probability weighting you put on the profusion of scenarios out there. If you think Napier and Edwards are nuts, you’ll probably maintain a heavy equity weighting. If you think there’s some possibility that they may be correct, you’ll take your equity exposure lower accordingly.

What do you think of these calls for S&P 400? Which bond market scenario would you endorse? Will higher yields come sooner or later?