The US share market has developed a case of the wobbles.
Is it just a long-awaited correction in a bull market with plenty more to offer? That seems to be the consensus. There’s been no panic selling.
The following from Sam Stovall, chief investment strategist at S&P Capital IQ, on CNN Money typifies this thinking: ‘I’d rather get the reset out of the way now because if we’re not careful it may end up becoming a bear market rather than a correction.’
But what if the wobbles are the start of something more sinister?
What if the Fed has used up all the water and can’t put out the flames?
Very few people spend enough time assessing risk (fear). But we spend too much time on the ‘what if’ reward (greed).
Yet psychological studies show we are wired for loss aversion.
The US share market (and by extension, the Australian market) recovery doesn’t pass the sniff test. You cannot solve a debt crisis by adding more debt. You cannot print your way to prosperity. You cannot suppress interest rates below their natural level without causing unintended consequences.
Economic history does not have a single example of these actions ever permanently succeeding. Sure, we can maintain the illusion of prosperity without productivity for some time. But it’ll eventually collapse under the weight of the deception.
History is firmly against the world’s central bankers.
As noted in yesterday’s Daily Reckoning, India’s central bank governor Raghuram Rajan, who forecast the 2008 financial meltdown, has warned that ‘the world economy faces risk of another market crash as asset prices surge.’
Rajan is applying critical thinking to the possible risk of a collapse in asset prices due to the central bankers forcing investors to chase ‘ever higher yields’.
Lower interest rates havedistorted investor behaviour and asset prices.
Therefore, anyone serious about wealth protection needs to consider what price the market may ask you to pay for the central bankers’ folly.
Are you mentally and financially capable of withstanding a market downturn of 90%?
That’s right — 90%.
I accept that putting such a figure in print invites derision and calls for me to be psychologically evaluated.
But let’s look at history. In 1929, the Dow Jones index reached a high of 381.17 points (to be precise). In 1932, the Dow hit a low of 41.22 points – a fall of 89.2 percent (again to be precise).
It took three painful years for The Great Depression to rip the heart out of investors. The Roaring Twenties became a distant memory.
Consider this: the Dow was last at 41 points in 1903, so three years wiped out thirty years’ of gains. A market intent on correcting excesses is brutal.
The Japanese market’s path to destruction was far more torturous. On December 29, 1989, the Nikkei hit an all-time high of 38,957 points. Nearly twenty years later, in March 2009, it bottomed out at 7055 points — a fall of 81.9 percent.
The Nikkei was last in the 7000 point range in 1983 — 26 years of gains blown away by a market extracting its revenge.
Both these extraordinary market corrections had one common denominator — too much debt in the system.
The debt levels in the system today dwarf the amounts that triggered The Great Depression and Japan’s demise.
A 90% fall is not without precedent. But how could it possibly happen? Here’s the math.
The share market, at its core, is a mechanism that places a price on the earnings of companies. The time honoured math to calculate value is the price to earnings (P/E) ratio.
For example, a company earning $1 billion x P/E of 16 would be valued at $16 Billion. Simple.
There are two parts to this simple equation:
The multiple (P/E) applied to those earnings
Both parts are subject to expansion and contraction.
The following chart shows the 140-year gyrations of the S&P 500 index P/E ratio.
The lowest P/E —five — occurred in 1917. The highest reading — 124 — happened in May 2009.
When you take out the swings and roundabouts, the long term median P/E is 14.6.
The S&P 500 index is currently trading on a P/E of 19.15 — a 30% premium to the median P/E.
Below is the S&P 500 real earnings (inflation adjusted) those multiples have been applied to.
The current equation for the S&P 500 index is as follows: A P/E of 19.15 is applied to earnings of $101.72, which equals 1,948 (the S&P currently sits around 1,932 points).
For the 40 years prior to 2000, S&P earnings remained within an inflation adjusted band of $30 to $50.
Since 2000, real S&P reported earnings have more than doubled during a period when US real wages have fallen. How is this possible?
A combination of technological gains, outsourcing labour and financial engineering (share buybacks, mergers and acquisitions, plus lower interest rates reducing debt servicing costs) have driven the higher earnings.
Overseas labour costs are rising. At some point, ‘creative accounting’ can no longer mask the anemic revenue growth. Technology is a question mark, but how much more can it lift the market?
What happens if Raghuram Rajan is correct and GFC MkII is unleashed on the global economy? Look at the earnings chart and see the temporary plunge in earnings created by the original GFC — they went under $15 for a full year.
The Fed’s actions steadied the ship and normal transmission resumed. But what if the next time the corrective forces are so powerful the Fed is rendered impotent?
What if GFC MkII clears the smoke and breaks the mirrors on US real earnings?
This is how you can get to a 90% correction. Real earnings fall back into the middle of the 1960‒2000 range — let’s say $40.
What if we apply the lowest P/E multiple of five (a reflection of the depressed mood investors find themselves in) to those earnings?
A P/E of five applied to earnings of $40 equals 200 — nearly a 90% fall from the current 1,932 point level of the S&P 500.
Guess when the S&P was last at 200 points? 1985.
As shown above, it’s not without precedent that up to 30 years of gains can be wiped out in a bear market intent on revenge.
Though history and math prove it’s possible, it’s hard even for me to fathom a fall of this magnitude.
But stranger things can and have happened.
Tomorrow, a strategy to cope with such a fall.
For The Daily Reckoning Australia