Effects Of The Coming Market Crash On The Economy - And Perhaps On You

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Includes: FB, SOCL, TWTR, XBI
by: Larry Kummer

Summary

The odds of a stock market crash are high.

Are you at or near ground zero, to be hurt by the crash or its after-effects?

Will you be affected by its ripples -- or the recession that probably causes the crash?

Here are the likely worst affected industries and regions. Prepare now if you're in them, or if you are over-weight their stocks.

A crash is coming soon. I believe (aka guess) it will happen in 2016, when stocks are knocked down by the combination of a recession, liquidation of margin debt, and collapse of valuations.

Valuations are a particular weak spot of stock. Now near record high levels, they are among the most mean-reverting of economic series on a generational basis (i.e., they collapse and then return to the average of the past 10 or 20 years). Stock prices might drop roughly by half, as they did after the last two bubbles popped.

What does a stock market decline do to the economy? Let's count the ways.

(1) Some people lose money

The short-term macroeconomic effects of that are small since equity ownership is concentrated. Only half of Americans have stocks or stock funds; only 20% have substantial exposure to the market -- and most stocks are held by the wealthy, for whom variations in net worth have little effect on spending. The long-term effects would be larger if real (after-inflation) stock values did not recover after five or ten years (the Dow Jones Industrial index was at 800 in both 1964 and 1982, a zero price-only return over 18 years -- and a real loss of two-thirds).

Do not become a victim. Be diversified and take no more risk than you can afford.

(2) Some people lose their jobs, or have their wages slashed

While the national effect will be small, just as it is from the downturn in the mining and energy sectors, some regions will be badly hurt. If you are in any of these I suggest strengthening your personal balance sheet and preparing an emergency parachute.

New York City and the San Francisco Bay Area will be among the most severely hit regions.

Finance gives New York City eight percent of its employment but almost a third of its wage income (i.e., from banking, insurance, investments). The 1970s bear market badly hurt NYC, back when it had a more diversified economy than it does today. (See the BLS and the NYS data).

A short bear market will force layoffs and lost bonuses for many employees in the financial sector. A long bear market, such as 1973-1982, might slash employment by one-third or more. Large scale efficiencies are possible in financial planning -- the first tax and financial planning experts systems were built in the mid-1980s; today they're good enough for most people. Ditto for portfolio management -- why pay absurd fees for below-index performance, especially as portfolio management software is good and becoming better?

But like #1, the macroeconomic effects of a shrinking finance sector will be large for NYC but small for the nation (although adding to the drag from the adding to the distress from the depressed mining and energy sectors). The financial sector (broadly defined) employees only 5% of America's workers.

The worst affected region will be the San Francisco - San Jose metro area, where the foundational industry is manufacturing stock certificates. The spending of this most volatile of businesses -- including that of its thousands of millionaires -- supports the Bay Area's economy of Uber drivers, restaurants, real estate, attorneys, stockbrokers, etc.

How solid is this foundation? What will be the fate of the hundreds of unprofitable companies (including those with negative cash flows) once the demand wanes for new stock certificates? Downsizing for most; bankruptcy for many. The carnage will be immense -- with effects rippling out through the Bay Area economy.

Two industries in the Bay Area will suffer most of the casualties.

a. The social media industry (NASDAQ:SOCL) will collapse

… leaving just the giants -- e.g., Facebook (NASDAQ:FB), a reorganized Twitter (NYSE:TWTR) -- and a few score niche players, much as the North American automobile industry went from thousands of companies to three.

Their problem is structural: Americans will pay for few non-essential services on the Internet (the dying middle class dooms many of the businesses and charities that serve them). So they rely on advertising, the supply of which can easily grow without limit. As we have seen, prices fall as the supply of advertising grows faster than its demand -- forcing internet companies to devise ever-more elaborate ways to display adds, and ever-more intrusive ways to collect their audience's personal data. It is a "Red Queen's race" where they run as fast as they can just to stay in an unprofitable game. Eventually the twin forces of consolidation and bankruptcy will prune the flock.

For details see The advertising glut dooms the social media industry.

b. The biotech bubble will burst

The flow of funds into the biotech industry (NYSEARCA:XBI) has been immense, making biotech stocks the hottest sector from 2011 to early 2015.

While socially useful, much of this capital will be burned. In 2013 and 2014 60% of biotech IPOs fueled companies with pre-clinical, Phase I, or Phase II drugs. This continued through mid-2015. The odds of success for a drug in Phase II testing is roughly 12%. The shares of such companies are lottery tickets, with odds and payoffs less than those at Las Vegas. When investors' demand for these tickets fades, the resulting downsizing will be severe (albeit taking place far more slowly than in the social media space).

For details see Don't ask if there's a biotech bubble. Ask why we have another bubble.

How does a market crash affect America?

Could a stock market crash plunge America into recession? By itself, no. The stock market looms large in the news today, disproportionate to its economic role. Things were different when I started with Loeb Rhodes Hornblower in 1979. The market's movements were considered trivia, like the scores of minor league baseball teams. It probably will become so again during the next bear market.

As we saw in 1987, the market can crash without a recession -- and crash without causing a recession. As discussed above, a crash will hit certain areas and industries but have little effect on the overall nation.

But it is more useful to look at this another way. The stock market is a mirror in which we can see the US economy, and the economy often drives stock prices. Both are true now more than usual. The next recession will depress corporate performance (e.g., sales, cash flow, and profits) and probably also push valuations below their long-term averages. Since equity valuations are near or at peak levels, the result could slash stock prices by 25% to 50%.

This second crash in two decades might disenchant investors and keep valuations -- and stock prices -- low for many years.

What can you do to prepare?

Investing success can come from adroit use of technical analysis (through I doubt that, given that technical tools have become so popular -- and hence more likely to accelerate a downturn than protect against one). But most great investors look out the window as well as at their monitors, seeing the real world events that move equity valuations.

Look at the economy to help you trade the markets. Today the warning signs are there and growing. Don't assume you will see and react to events ahead of the crowd. Proactively reduce your exposures as appropriate for you. Tighten your risk control methods. Stay alert. Exciting times are coming.

Other articles in this Seeking Alpha series:

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.