- From time to time those of us who are intrigued by human nature get a chance to witness mass hysteria, courtesy of the markets.
- Human nature being what it is, this involves shocking swings between euphoria and panic; this volatility has been played out repeatedly, such as in 1929, 1987, 2002, 2008, and 2020.
- Mr. Market punished prudent investors for years during the formation of the bubble, rewarding the most careless punters for "buying the dips," only to suddenly change the game without notice.
- But there are always warnings that prudent investors could've used to limit their risk; whereas inexperienced optimists and the greedy have walked right over the precipice, once again.
- Prudent investors should cut their exposure to SPY, DIA, and QQQ during any rallies; they should consider holding WHOSX, TLT, IAU, SLV, and OTCRX.
From time to time, those of us who are intrigued by human nature get a chance to witness mass hysteria courtesy of the markets. Human nature being what it is, this involves sometimes shocking swings between euphoria and panic (Chart 1). This kind of swing from one irrational belief to another has been played out by Mr. Market on many occasions, including during the long-lasting Great Crash of 1929-1932, which virtually destroyed investors with losses totaling 89% (cf. Kevin Wilson, 2018a). There was also the demise of the Nifty Fifty in the 1970s (cf. Kevin Wilson, 2016a), the shockingly sudden 30%+ Crash of October 1987 (Kevin Wilson, 2016b), and the extended, truly devastating Dot-Com Crash of 2000-2002, which treated Nasdaq (e.g., Invesco QQQ Trust [QQQ]) speculators to a massive 77% loss (cf. Kevin Wilson, 2016c; Tara Clarke, 2015). Of course, there was also the Great Financial Crisis of 2007-2009, which pounded investors with a 54% loss on the S&P 500 (cf. Kevin Wilson, 2019a). In each of these cases investor euphoria led to very high or even extremely high valuations that had little or no grounding in actual fundamentals, but was instead driven by a popular theme that it was "different this time." Each of these cases ended in huge losses for those who bought in late (because the most shares are generally bought at the top) and/or those who hung on regardless of the downside risk, until major losses had accumulated (at least on paper, but often enough as realized losses).
Chart 1: The Emotional Roller Coaster of the Markets
An historical event that looks a lot like the present (perhaps only partially-done), rapid draw-down is the famous Crash of October, 1987 (Chart 2), which was not accompanied by a recession, but nevertheless involved a very rapid loss of over 35%, including 22% on a single day. It owed its relative violence to at least four things: 1) high market valuations and complacency in spite of obvious risks; 2) the acceleration of losses via computer-generated trading programs (cf. Kevin Wilson, 2017a); 3) a strong divergence between the markets and the economy; and 4) a strong dollar that was hurting exports (Troy Segal, 2019). Recovery after the 1987 tumble was swift, but the pain was very real for many people. An entire generation of investors was so scarred by the 1987 crash that for decades afterward, the most common dates on CD maturities were in late October, echoing the time interval of the crash.
Chart 2: The Dow Jones Industrial Avg. in the Crash of 1987
What seems to be a theme in all such dramatic sell-offs and panics is a euphoric march to the edge of the precipice, and then a sudden, "surprise" drop that instantly dispels the euphoria and replaces it almost immediately with alarm, fear, or even panic. This is merely the capricious action of Mr. Market, who seems always to revel in a sort of recreational cruelty, in which he seems to enjoy setting up scenarios in which the maximum number of people get caught off-guard, whichever way he's inclined to go. Thus, Mr. Market punishes cautious or prudent investors for years on end during the formation of a bubble, rewarding the most cocky and ignorant amongst us over and over for "buying the dips," only to then suddenly reverse the way the game works almost overnight. So yet again, many people have been suckered (due to the inherent irrationality of humans) into placing their biggest bets very near the top of the cycle (or alternatively, over an extended period of time at high valuations while the topping process is going on), because this approach "has worked for years." And each time, as if every new group of players is incapable of learning from the past, Mr. Market then cheerfully hands them a learning experience in the form of spectacular losses. These huge losses seemingly arise without any warning at all (but in reality are always somewhat predictable as to their extent based on certain fundamentals, although the timing is never predictable in any detail).
The latest debacle (Chart 3), starting on February 20th, certainly appears to represent yet another exercise in capriciousness by Mr. Market, and many have already been hurt by it. Although the market has not yet dropped 20% as I write this, and therefore is not yet technically a "crash," it is still the fastest 10%+ drop from a new high ever, and two of the rolling five-day periods over the last two weeks qualified for a list of the fifty worst five-day periods since 1920 (Lance Roberts, 2020). It certainly looks and smells like a real crash. For comparison, there were only five such five-day periods during the entire Great Financial Crisis, five more during the 1987 Crash, and a total of 22 during the entirety of the Great Depression. This time around has featured the markets (e.g., the SPDR S&P 500 ETF [SPY]) dropping vertically for seven straight sessions so far. The technical and psychological damage done is already quite serious, and they are likely to result in further losses; however, since we are now massively oversold, a strong counter-trend rally will likely occur along the way. It is not clear where the bottom of this particular sell-off is likely to be. If it is merely a correction, then another 5% to 7% of downside (beyond the present low) is likely after the expected oversold bounce. However, if the market cycle is actually ending and a bear market has really begun, then the bottom is somewhere between a 25% loss (as optimists would expect in their "worst-case scenario"), and as much as 65% down (as quantitative estimates of the over-valuation and regression to the mean would indicate based on market history (cf. John Hussman, 2020). Now before you sneer that Hussman is a perma-bear, consider that his estimates of the ultimate draw-downs in bear markets have been right on the money for well over 20 years. It's only his timing that has been a problem.
The Reasons for the Latest Panic
I have personally been warning of the potential for a crash to end this cycle for quite some time now (e.g., Kevin Wilson, 2016d; Kevin Wilson, 2017b; Kevin Wilson, 2018b; Kevin Wilson, 2019b; Kevin Wilson, 2020a). This no doubt makes me appear to be the "Boy Who Cried Wolf," and also perhaps some kind of perma-bear, but really the conditions for a market crash have been in place for a very long time. Indeed, the long delay in the onset of this crash has merely increased the risk of a violent and very damaging reversal and increased the potential size of the losses; it has been caused (in my opinion) by some fairly unprecedented circumstances. However, the tune played by the market sounds very familiar and many of us can easily hum along even if we don't know the words.
First, we've witnessed the Fed and other major central banks adopt as their acknowledged goal, the deliberate driving of asset prices ever higher over a period of many years. This was allegedly done (via injections of excess liquidity) merely to help them in their quest for the illusory "wealth effect" that would supposedly serve to boost their respective ailing economies. This collective effort of central bankers in the never-ending manipulation of the markets was amazingly wrong-headed and has failed to boost their respective economies; however, asset prices have long-since been driven almost entirely by monetary policy interventions (cf. Kevin Wilson, 2019c). The Fed's easy money policies under two presidents have thus provided constant stimulation for renewed speculation via record-high margin debt, and that has certainly been a factor in blowing up the recent asset bubble (Chart 4). Second, the provision of all that easy money from the Fed's actions, in combination with (and exacerbated by) the Trump Administration's corporate tax cuts, has driven huge corporate stock buyback programs that have been the other, and even more important, main engine powering the markets ever higher (Chart 5).
Chart 4: Margin Debt Has (In Part) Driven the Rally
The artificiality of the rally has long been apparent, just as it was in the lead-up to all previous major crashes. So although this current plunge is not yet a major crash, it will likely become one. Already at least $3.6 trillion of paper losses have been racked up (Akane Otani & Peter Santilli, 2020). Yet anyone could have observed certain warning signs, e.g., that the yield curve inverted six months ago (Chart 6), indicating a growth slowdown or recession is imminent; yet the market has soared over many months as more money flowed in, apparently in anticipation of more easy money from the Fed. This speculative action was taken by many professional people and some retail "investors," who were presumably all driven by somewhat heedless greed. So this was one widespread collective response to a well-known warning sign; indeed, this group raised their risk rather than the alternative of preparing for the worst.
Chart 6: Yield Curve Inversion for 10Yr.-2Yr. (in Late 2019)
Not that other people with more experience or less optimism ignored the warnings; far from it, as we know that inflows to bond funds absolutely soared in recent weeks (Sunny Oh, 2020). Also, the 30-Year Treasury Bond's yield has been in a prolonged plunge (Chart 7) since late 2018, again indicating a serious growth slowdown or recession is on the horizon, but this has mostly been ignored until this week. Not only that, but corporate profits as a percentage of GDP have been falling ever since 2013 (Chart 8); this means that much of the rally has been driven by multiple expansion, not earnings gains. This shows up in the extreme valuations recently observed, as seen for example in the recent, unprecedented median price/sales ratio (Chart 9) which towers above all previous market peaks. There is also the fact that market breadth has recently narrowed to a level that rivals that of 1999, in that only five stocks now represent a whopping 19% of the S&P 500's market cap (Chart 10).
Chart 7: Prolonged Plunge in 30Yr. US Treasury Yield
Chart 8: Corporate Profit/GDP Ratio Falling Since 2013
Chart 9: Median Price/Sales Ratio At Record High
So there have been a number of warning signs that people could have and should have noticed. There are in fact many more we might mention. One that really stands out to me is the Household Net Worth/Nominal GDP Ratio, which has again soared to unprecedented levels because of the Fed's serial bubble-blowing (Chart 11). The majority by far of that wealth increase belongs to the so-called "1%," which has exacerbated wealth inequality and is part of what has been driving the recent wave of populism in politics. Each of the previous two such net worth bubbles deflated rather violently with huge losses. Another indicator people would have done well to notice was the failure of the Trump corporate tax cuts to significantly increase corporate investment (Chart 12), suggesting that corporations either don't know anymore where to invest (cf. Kevin Wilson, 2020b), or don't see any prospects for growth if they do invest.
Chart 11: Serial Bubble Blowing By The Fed
Chart 12: Fiscal Stimulus (Tax Cuts) Have Had Little Effect on Corporate Investment
Forever New to Some; Old News to Others, But With a New Twist
The whole reason crashes happen is the intrinsic irrationality of human nature (cf. Kevin Wilson, 2016e; Kevin Wilson, 2018c). It is natural therefore that most of us want to buy high and sell low (following the herd), especially when there's a bubble working to inflate prices and provoke the emotions of "investors" and speculators. That doesn't mean that we can't buck the trend, but it's a given that most of us won't be able to do it. However, based on fund flows, something somewhat different has happened this time around. In fact, the cumulative amount of capital flowing into equity funds dropped off as the market soared in 2018 and 2019 (Chart 13); however, just as the recent top was produced, the trend reversed and money started flowing in again (Chart 14). If we look in detail at corporate buybacks, we can see a fall-off in activity there as well (Chart 15).
Chart 14: ...But Right at the Top Flows Picked Up Again
Chart 15: Buybacks Have Massively Declined in Volume Recently
So what exactly has driven the markets higher? It must involve cash flows mainly to individual stocks rather than just funds, but it hasn't involved corporate buybacks as much as it previously has done. The sources of the most recent leg of the rally must have (of course) included program trading in individual names by professionals (e.g., hedge funds, etc.). But another factor that may be considered new this time is that never before has so much money ($2.5 trillion) been tied up in passive funds like index ETFs. They have drawn down their cash levels in order to stay balanced (i.e., buy over-priced stocks at their highs). Just look at the massive capital inflows to passively managed funds (and away from actively managed funds) since 2014, as investors have chased returns in a market that has lost any pretense of price discovery (Chart 16). Consider also that index funds must re-balance to the index periodically, and in doing so they naturally acquire more of the most expensive (over-valued) shares as a market top is reached. This leads to exaggerated losses when the inevitable sell-off finally occurs. I believe this could be a major component of the sudden, severe losses we've experienced this time around.
Chart 16: Investors Have Chased Returns Since 2014 By Massively Buying Passive Equity Funds
A prudent investor, or at least one who has just decided that discretion is the better part of valor, would now be wise to take stock of the market risk scenario now that a major crash may have begun. The upside, assuming this is just a correction, might be estimated at about 12% beyond the current level (thus taking the S&P 500 up to around 3310), assuming that earnings growth turns out to be right on track (and assuming no further expansion of the multiple). Both assumptions are questionable however; the first because earnings estimates have been ridiculously high in recent quarters and are likely still woefully incorrect, and the second because the only impetus likely to expand the multiple at all would be a Trump victory in the fall (but right now that looks more likely than not). So let's drop the earnings-driven part back down to about a 7% gain counting dividends (i.e., a target of 3160). But it might be reasonable to tack on another 10% for a Trump re-election rally, which might take the S&P 500 up to around 3480. Note that even this rosy scenario is only about 3% above the most recent market high.
Now look at the potential downside risks. First, we have a global slowdown or recession that is likely just starting in some places (e.g., China, Germany), but already ongoing in others (e.g., Japan). However, the coronavirus epidemic has now likely accelerated the downturn throughout Asia, spreading into Europe as well, due to quarantines and stopped production in many localities (WSJ By the Numbers Column, 2020). This does not yet include major business problems in the US, which obviously could potentially yet arise. Another month or so of this global business shutdown and a global recession, long anticipated (cf. Kevin Wilson, 2018d), will become almost inevitable. Spillover to the US economy would also become inevitable. In that scenario, it is quite reasonable to expect the 65% market drop that John Hussman (2020; Op cit.) has estimated based on unprecedented valuations and regression to the mean.
So now if we add this all up, the maximum likely upside in a perfectly optimistic market scenario for the rest of this cycle might be on the order of +17% from where we are (S&P 500 = 2954 today); the maximum likely downside is on the order of -65% from the recent high, or another 60% drop below the close on Friday, February 28th, all the way down to an S&P 500 price of only 1185. This is a highly asymmetric risk scenario, and anyone who is not a confirmed buy-and-hold investor capable of withstanding such huge losses should either be massively reducing their risk exposure, or should already have done this.
The stock market is subject to highly asymmetrical risk going forward, and prudent investors should limit their exposure to equity risk. This means that the SPDR S&P 500 ETF (NYSEARCA:SPY) should be reduced in portfolios to the minimum amount held during recessions based on personal risk tolerance. The same would hold true of other equity indexes such as the SPDR Dow Jones Industrial Avg. ETF (DIA) or the Invesco QQQ Trust (QQQ). Long bonds have soared recently to new all-time highs, but if there is a decent counter-trend rally in equities, long bonds will fall somewhat and could be bought again. Examples might include the Wasatch-Hoisington Treasury Fund (WHOSX), and the iShares 20+ Yr. Treasury Bond ETF (TLT). After the 10-Year US Treasury nears a (prospective) yield of about 0.50%-1.00%, or whenever the impending bear market for stocks bottoms (whichever comes first), I would expect a very high risk of a bond selloff, and depending on circumstances it is possible it could even be a very big one. So buying long bonds here or on the next pullback is more likely a trade, rather than an investment.
It makes sense with all the uncertainty, deflationary trends, and negative real rates to invest some money in a gold fund like the iShares Gold Trust (IAU), or the Sprott Physical Gold Trust (PHYS), an alternative gold ETF that may be safer for those who want to hold it for a somewhat longer period of time. But perhaps the safest form of gold in the event of a true financial apocalypse is actual physical gold (in hand). I also like the way silver looks on the charts, and its recent pullback was more likely than not based on margin calls, just as we saw happen for gold in 2008. Note that following that early sell-off in 2008, gold rallied for over three years to new highs. The iShares Silver Trust (SLV) is a likely vehicle for those who want to use silver as a hedge. For those discounting a possible near-term recession and bear market, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX) could also be held in order to protect assets in the event of a much sharper market drawdown associated with deteriorating economic data.
This article was written by
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