By Univ.-Prof. em. Stefan Gueth, M. Sc.
A quick email exchange with Damon Verial motivated me to write this article. In a previous rather short post a visual analogy between the price development of stock markets in 2007/2008 to the price development between October 2014 until today was drawn. Both periods look absolutely the same, with the current period appearing as a zoomed and stretched version of the period 8-9 years ago.
What followed 9 years ago after the October 2007 peak was a harsh economic recession lasting 18 months until April 2009. Damon`s question regarding the chart in the previous article that concentrated on the DAX as barometer for the European Stock Markets, whether this might occur just based on technically driven reasons (meaning performance driven without bad fundamentals) or if there is more to it. Yes there is, namely a bad receipe that is usually avoided to be mentioned by the majority of market participants as most are long-only investors. What bad receipe am I talking about?
Whenever a rise in the stock market is debt-fueled, a cap is reached when the level of debt (public and private) reaches a cap where no more debt can be accumulated by the debtors due to having accumulated too much already and creditor become unwilling to lend further. As a first sign corporate debt restructuring becomes more frequent and the number of corporate defaults go up.
Read this report about the number of defaults from ft.com (Source:next.ft.com/content/a0ea3972-0356-11e6-9...) and also that article from the Financial Times (Source:next.ft.com/content/5a983506-fd79-11e5-b...) and we can cross this in the checklist as confirmed.
When you have read both articles, you should wonder why there is in both articles the Oil Price as Energy Price topic appears infused. Well, that the bad receipe that I mentioned but everyone else tries to avoid to mention at all: both positive and negative oil-price shocks appearing at comparatively high levels of debt that correlate with comparatively high levels in the stock markets create a receipe for desaster: a major global crash.
This chart compares the annual dollar growth in total new debt (public and private) against the S&P 500 level and illustrates how the 2003-2007 market rally benefited from massive new debt creation, peaking at roughly $4.7 trillion annually in December of 2007. Each time series is adjusted for inflation via the headline Consumer Price Index and smoothed using a 3-month moving average. The red arrow marks the peak in September 2007 which is the level comparable to the current debt today.
This chart compares the daily price of crude oil versus the level of the S&P 500 over the last 10 years. The blue arrow represents the risk of oil prices shooting up interacting with the red arrow representing stock market prices, here of the S&P500 dropping sharply.
For the still disbelieving reader, here the last nail in the coffin: the consumer. Every single recession with large measurable effects for the consumer is triggered by a positive price shock of a suddenly exploding energy/oil price. The keyword here is suddenly. Not only industries but especially consumers have enormous difficulties with a suddenly changing energy price environment.
This is what creates the receipe for desaster: a debt-fueled stock market begins to crumble due to a series of a number of defaults which is significantly larger than anticipated. Within this debt-default environment previously low energy prices explode out of nothing leading to a quick and large price spike that hits most industrial players unprepared and especially the consumer unexpected and sudden, leading to an inevitable and equally sudden crash of stock market prices globally.
Are there any good news to it? Yes, there are. First of all, there are still at least a couple of weeks, maybe even 3 more months time to reduce equity positions and look carefully at which bond issuers are likely to default and which are not in order to shift default risk towards issuers with enough cash and current assets worthy of lending.
Second of all, you can invest into Oil ETFs and stocks which might benefit from a rising oil price. You can also invest into sovereign bonds of countries which are likely to benefit from a rising oil price or in businesses that profit in these countries from a rising oil price due to higher investments and higher consumer spending.
Thirdly and lastly, after any mean reversion you can prepare your shopping list of those companies you would like to buy right now, but Price-Earnings Ratios are not really attractive yet. If there is a very sudden price drop in share prices globally, meaning over a rather short period of time, say 6 months or less, it is very likely that latest by March 2017 such a mean reversing event would have completed. The good news is that for very quick and sharp price drops, the fundamentals of a company stay intact, therefore also a company`s earning capacity. The sharp price drops are rather panic sales and in the end, those who are prepared with cash will be certain to profit for at least the next 8-10 years to come - provided they bought oversold solid firms with solid fundamentals.
If the event will unfold as described, the author will create a shopping list for the interested reader and post it as article at SA.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.