Is a 50% Market Decline Possible?

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Before we get stuck into today’s Daily Reckoning, just a reminder to watch out for a special report from Gowdie Family Wealth editor Vern Gowdie tomorrow. Vern makes some pretty big claims. We won’t go into it here, but if you think we’re bearish, check out Vern’s well-reasoned analysis for a comparison.

Not that we’ve gone soft or anything. In fact, we’re just putting the finishing touches to our latest issue, wherein we make the case that a 50% fall in the S&P500 is not only possible over the next few years, it’s entirely probable.

That may sound extreme, but it’s happened plenty of times before. It happened after the 2000 tech bubble and after the 2007 US housing bubble. It also happened after the long post-Second World War boom ended in the late 1960s.

Amid investor euphoria following two decades of solid gains, the market topped out in December 1968. While most market players were completely ignorant of the coming six year decline that wiped 50% of the value of the S&P500, there were a few people who could see what was coming.

One of them, known only as the ‘Gnome of Zurich’, saw rumblings in the gold market as a sign of things to come. He was ringing the bell for the top of the market while Wall Street investment whizzes continued to trade bits of paper with each other.

So is another washout likely? We reckon it is, and there are rumblings in the gold market too. Although we’ve been saying that a big correction is likely for a while. On the other hand, our mate Kris Sayce over at Money Morning reckons the market will keep going up. He says there will be corrections from time to time, but the general trend is up.

And we can’t disagree there. The trend is up…at the moment. But trends change, and we think the market is going through a major topping out process.

Many people have a problem with the fact that we don’t all share the same view here at PPP headquarters. But that’s what makes a market. In addition to the robots (who seem to be accounting for more and more of the trading volume these days) the market is just the collective force of millions and millions of individual investment decisions.

Opinions form these decisions, and biases form opinions. So whenever you hear someone form an opinion about the market, ask yourself, what is their personal bias? We can’t speak for Saycey, but we know our own biases well. As a value investor, we only want to buy stocks when they are good value relative to the risks involved. So we have a strong bias to want to see lower stock prices from here.  

Judging risks and value is always a subjective call. Risk, like beauty, is in the eye of the beholder. That’s why we (and Vern) like cash right now, while many others are doing anything they can to get out of cash and into dividend paying stocks.

We see the risks as being too high to justify a large exposure to the market. So we wait it out in cash. It’s not that we’d prefer cash, but the alternatives are unpalatable. Our bias is to want to invest in cheap stocks…that is, companies that will, over the long term, reward you for the risk of being an equity owner in an unpredictable business.

And at current prices, we just don’t think the long term owner of a business is going to receive an adequate reward for the risks involved. It’s as simple as that.

Central banks are forcing you to take risks which mean you’re really speculating that they can continue to force new people into the market, pushing prices higher and higher. Well, that dynamic has been in force for years now. We’re not certain that’s there’s many more marginal investors to keep the buying pressure up.

More importantly, this investment behaviour actually supports lower prices over the longer term. Take the recent Aussie reporting season. One of the main themes was an increase in the dividend payout ratio. That is, companies are reinvesting less into their businesses and giving more to shareholders.

So instead of increasing their net worth through reinvestment (and compounding those reinvested funds) a higher proportion of company earnings go to investors, who either buy more stock with it or consume it.

If you think about it, this is not good from a long term perspective. If companies don’t reinvest then it makes it hard to generate sustainable earnings growth. Without earnings growth you get little to no growth in intrinsic value. So even though reinvested dividends might push up share prices, the intrinsic value of the company isn’t increasing, and it may even be falling.

A higher share price with little to no earnings growth simply reflects a stock getting more expensive.

We’re generalising here to make a point. The point is that higher dividend payout ratios might sound good to shareholders thirsting for income, but it undermines a company’s long term intrinsic value by having the board make capital management decisions to satisfy the short term demands of investors rather than the long term demands of the business.  

Before we sign off we’d just like to highlight the astounding fact that we didn’t make one disparaging comment about China this week. That must be some kind of record. We haven’t changed our views, but the story is becoming a little mainstream now.

This week, both the Wall Street Journal and the Financial Times published a series on China’s debt woes. When that happens, the turmoil tends to quieten down for a while. But we expect more problems to emerge in the months ahead. We’ll be sure to let you know about it too!

Have a good weekend…

Regards,

Greg Canavan+
for The Daily Reckoning Australia  

Join The Daily Reckoning on Google+

From the Archives…

Richard Fisher’s ‘Super Easy’ Fed
23-08-2013 – Nick Hubble

US Stocks and the Timeless Wisdom of Izzy Stone
22-08-2013 – Chris Mayer

Bankers Profit at the Expense of the Broader Community
21-08-2013 – Vern Gowdie

A Bond Market Tantrum

20-08-2013 – Nick Hubble

Australia’s Economy: Complex, Fragile or Centralised?
19-08-2013 – Nick Hubble

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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5 Comments on "Is a 50% Market Decline Possible?"

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Ross
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Ever forgetfull of the effects reverse carry at also at risk funding source…. remember what they had to do with liquidity to deal with that last time? This time the swaps in emerging markets have started between those other than USD denominated as in the case of Indonesia’s deal with Japan. No word yet on the closing of the hot money positions by the usual suspects in the US. Meanwhile, AU/NZ/GB mortgages are yet to be called a risk market, or a submerging market. http://www.economist.com/blogs/dailychart/2011/11/global-house-prices GB is testing their status by not joining in the shooting at Syria, we might… Read more »
slewie the pi-rat
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my [US] bias is that the bankster holding companies, coupled with the bankster-controlled market-makers and other investment banksters, have a functional monopoly on stocks and the pricing mechanisms, operating under Dodd/Frank’s new constructs, in unholy tandem with the Treasury and the PPT, and happily so. with the TBTF credit ratings, asset control, a functional spectrum of trading controls, and Puppet Master ‘oversight’, this is not my grandfather’s ‘market’; nor dad’s; nor even mine. frankly it has all started to look like a big utility, to me. with casinos attached. i think the fundamental analyses are great: deconstructing the statements, the… Read more »
slewie the pi-rat
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Syria seems to have put an end to the Good Cop spin, eh? #1. well, the government is still defending the nation pretty well, and that seems to be derailing the ‘political’ settlement agenda? #2. not quite sure how ya reach a political settlement in what seems to have become a sectarian religious fiat-fueled banshee & assassin jamboree; especially when #3. the US will not sit down and make a political settlement under #1. (!) i’m having trouble differentiating the sectarian religious fiat-fueled banshee & assassin jamboree from the chem weapons use during said anti-human religious killing jamboree, on my… Read more »
Ross
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full spectrum dominance slewie

Lachlan
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“Syria seems to have put an end to the Good Cop spin, eh?”

They are doing well. Yet I am sure they know better than anybody what is coming. Conformed banking and business.

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