Nightmare For 401(K)ers: Assets May Go Down By 50%

by: Thomas Barnard

Summary

Average S&P 500 P/E has been above 20 for 22 years - unprecedented.

Average S&P 500 P/E was only above 20 for two years before the 1929 Crash.

Before the current period, the longest period the average S&P 500 P/E was above 20 was six years (1963-69).

And Just When You Thought You Could Quit Thinking

John Bogle of Vanguard has been extolling the virtues of index funds for years. And we are not questioning his point about the fees paid to managers, these are plainly lower. But his other point is that it is near impossible for managers to beat the indexes, and that may be true also.

Our issue is with dollar cost averaging.

Dollar Riddle me this Batman: what do you do when you have been dollar cost averaging over the past 20 years, during which time the average P/E has been an unprecedented 25.85, and we end up in an era like the 1980s with P/E at 11.34. On the surface, that looks like a decrease of 60%.

Bad enough, right? Horrible. But then maybe you enter the Land of No Return, which we are living in. Returns are awful now. So, you could end up with half as much money and not be able earn anything that you have left. A bad dream inside a nightmare.

This is the problem, which we have been faced with since the advent of the 2008 crisis. The Fed reduced the re-discount rate to nothing. That's part one. Then the Fed started buying mortgage bonds at a clip of $80 billion a month. The investors who held those bonds received huge amounts of cash but no good place to put it. They could not earn anything on their money, so they put it in the stock market, which has recovered from 7062 to 18,132. So that is straightforward.

Lower Gasoline Prices Are Not a Good Thing

Maybe the Saudis are producing flat out to keep the Iranians from getting anything for their oil. Maybe the Saudis are trying to wipe out the frackers. But what is for certain is that demand is not particularly strong, and I mean China.

And low demand is the problem they faced all during the 1930s. A problem they never really solved convincingly, until World War II.

The Problem with Stimulus

The problem with stimulus is probably the same thing that happens with clinical psychologists: after a while it doesn't work anymore. Do you remember when Reagan cut taxes from 70% to 50%? It was a boon to the economy, but now the top rate is 39%. There is nowhere to go on the downside; the current rate is not even sufficient to balance the budget. Yes, you can cut spending, but remember when you do that, you are also cutting stimulus, which means, ultimately, you are cutting jobs, and taking money from consumers who make the whole thing work.

The Federal Reserve is realizing, to its chagrin, that it has no tools in the toolkit. It has lowered the re-discount rate to nothing, and now it has raised it to .25%, which is still nothing. If a disaster hits, they can drop rates .25%. Big deal. It can buy bonds again. But the problem, which they will realize is that they have created a stock market bubble buying bonds.

So, do you get it yet? You can't do a Reagan tax cut; rates are already too low to fund the government. The Fed cannot lower rates in any kind of effective way, rates are low. Congress can spend, but that is what Japan has done for years and never created any real growth.

Further, the economy was bolstered from 1980-2000 with the advent of the personal computer, the build out of the internet infrastructure, and the cell phone (and associated infrastructure). A wave of innovation is no doubt lurking out there in the future, but it is not present at the moment.

Why now?

Harry Dent has what he thinks is the closest thing to a crystal ball, and that is demographics. It's a foggy crystal ball at best, because Harry Dent is wrong a lot of the time. He thought the Dow would have been down to 6,000 by last summer. Oops.

But the demographics are very interesting. According to Dent, baby boomers are really hitting retirement, which means they will be spending a lot less money. Never good for demand and GDP.

The Strategic Fresh Water Reserve

It looks like the only sensible thing to do is to do some sensible infrastructure - roads and bridges. I think it would be sensible to build a Strategic Fresh Water Reserve, which is to say, pipe out floodwaters to the Ogalala acquifer. It seems crazy that we have not figured out how to save all that fresh water when there is flooding. You can always spend more money on cool new military toys, but I would say we need an Eisenhower, who was only willing to spend to maintain an advantage and not a penny more.

The Fallow Field

But after that spending, maybe you have to let things right themselves for a while. Take the cure, and admit that spending is not working now, especially when you are creating enormous debt, no matter what Krugman says. Maybe try huge spending again when things have hit a bottom.

The Crystal Ball

I'm not calling the market; I have thought the P/E ratio was way out of whack for years and years. Consider, the longest period of a P/E over 20 was from 1963-69, a mere six years. The average P/E has been above 20 since 1993, some 22 years.

Dial back the clock, and using Shiller's spreadsheet, there have only been 4 times that the market has sustained a P/E of over 20 since 1881.

1898-1902 - 4 years

1928-1930 - 2 years

1963-1969 - 6 years

1993-2015 - 22 years and counting.

Harry Dent, author of The Demographic Cliff, thinks that he can call the market based on demographics. For example, he thinks that since the baby boomers are now moving into retirement that they will be spending less. I think that is true, but with GDP moving up 2%, I don't know that you can see it.

Since China's market collapsed last summer, and has collapsed again, it looks like that will be the proximate cause of a market collapse, with demographics being a contributor.

From Dent's point of view, Trump's campaign for a wall against Mexico looks laughable. Economics is still a numbers game, and since our birthrate is nothing special, we actually need Mexican immigrants, but according to Dent, net immigration from Mexico is zero. He argues that Japan's declining birthrate plus negligible immigration is a continuing disaster for that country, which QE and spending cannot solve.

Anecdotally, a contractor told me that after the collapse in 2008, Polish workers have gone back to Poland, Irish workers have gone back to Ireland, and Mexican workers have gone back to Mexico.

Anecdotally, a manager who travels to China 5 times a year told me that a few factories she was using have gone belly up.

I take these things to be things my economic cat's whiskers have hit in the dark night of prognostication.

Why Have Stock Prices Been So High For So Long?

In the 1990s, we were in a truly remarkable period, the innovation of private enterprise was astounding with the advent of the personal computer, the cell phone and the cell phone network build out, and the internet and that build out. It appeared that to discount the future of these inventions would add years to the normal amount a businessman would be willing to pay to buy a business, which I would take to be 6 to 10 times a year's earnings. So, a P/E above 20 for this moment in time seemed sensible enough.

Since then, it seems like stock prices have been artificially maintained at these high levels by 3 things:

1) Quantitative Easing. The Fed was buying mortgage bonds at $80 billion a clip for months and years. When the seller received his cash, he could find no good place to get a decent return (also engineered by The Fed), so some of that money went into the stock market in search of better returns. This has worked up until the present moment.

2) Continued purchases of stocks by pension funds and owners of 401(k) plans.

3) Corporations buying back their own stock to reduce the number of shares and increase per share profits even if gross profits are flat. It would seem that corporations should only buy back shares when shares are below book, but that kind of thinking seems old fashioned these days. But then I'm not a corporate executive with a wad of stock options.

So by now, the market is saturated with personal computers, everyone has a cell phone, so much so that public coin-operated telephones are gone, and the internet is everywhere. That plus the baby-boomers are retiring and spending less money. That plus China way over-built (witness the empty cities photographed by 60 Minutes). Saturation is the enemy of economic growth.

The earnings for the S&P 500 this year were uninspiring, which also argues against a rich valuation for stocks. There is no need now to pay a premium for a business, which is only going to earn at a normal rate.

So, I don't think it's such a shocking prediction to say that before this is all over, stocks will drop to single digits for a long time.

What Should Investors Do?

Move to cash.

Cash looks like a reasonable thing to do. You cannot earn anything on it, but then, you won't lose half of it. When stocks hit the single digits, see if there aren't any reasonable returns. Interest rates may have righted themselves if the Treasury finds it cannot sell bonds on the cheap anymore. After all, the Chinese may sell bonds, not necessarily as a political act, but to raise funds to solve its economic problems.

Gold does not look like it will be particularly attractive. Oil is going down. If the economy rights itself, bonds will be set to go lower as interest rates regress to the mean. That inverse thing with bonds, as interest rates increase, bond principal declines.

One can buy stocks that are paying dividends, but you must look carefully at the prospects for the business, because it often happens when things go south so do dividends, which might even get suspended. Think of GM. Make sure the earnings are well above the dividend, in the business they call that coverage. I wrote previously on this same subject and suggested dividend stocks there.

Such dividend stocks may act as interest rate vehicles, and may be resistant to stock price declines that the rest of the market is suffering, but only if the earnings guarantee those dividends.

One may short the market, or bet the market will go down. There are vehicles for such activities - the ProShares Short Dow 30 ETF (NYSEARCA:DOG), for example, and there are many more, check out here. It seems unpatriotic to short the market, but if the market goes down, at least someone would have money to buy shares again. Otherwise, it is just a total loss of value.

Understand that you may be responsible for dividends when you short, and markets may rise. And most importantly, the market has been overvalued for years, and that may continue.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.