Whenever you step outside the orthodoxy there is fair chance of being called either brave or stupid – mostly the latter.
Going out on a limb is especially brave or stupid in this modern world of instant recall. Whatever you said or did can be relayed around the world with the click of a mouse – just ask Paris Hilton.
Recent feedback from a reader reminded me of this daunting prospect.
‘I am saving your 90% crash prediction and will look it up in five years.
‘As an older, experienced investor, and part-owner of a family business, I have never seen as brave a forecast as yours – well there have been some almost as extreme predictions of boom, but never, ever a suggestion of 90% down. I hope you have good professional indemnity cover.
Firstly I would like to thank John for being kind and saying my forecast was ‘brave’, rather than stupid.
Secondly, there are a few topics I picked up that are worth expanding on:
- 90% crash prediction
- Experienced investor
- Good Professional Indemnity cover
There is no doubt the mention of a 90% correction in the share market places me ‘way off the reservation’. I accept that.
As with all things mathematical there are probabilities that can be assigned to assumptions. Is a 90% a high or low probability? From where we sit today it is a low probability, however it is possible.
However, before delving into the math behind the possibility of a 90% correction, let’s look at the ‘experienced investor’ statement.
If you have been around the market for a long time – say 20 to 30 years – there is no doubt you have gathered experience. Personally I have been through the 1987 crash; the ‘recession we had to have’; the commercial property boom and bust; the Asian crisis; the Tech boom and bust; 9/11; the 2003 to 2007 market boom; the GFC, and have seen interest rates in the high teens drift down to 2.5%.
John may have investment experience going back even further in time. However, my theory (which underpins the Gowdie Family Wealth portfolio) is the experience gained over the past 30 or so years is largely irrelevant.
The same as being an experienced pool swimmer does not make you an experienced ocean swimmer. If you have never contended with waves, undercurrents and sweeps before it can be quite a challenge maintaining your swimming stroke.
The relatively positive conditions that influenced the investment world over the past 30+ years (and even going back to the Second World War) are not the ones we are going to encounter in the coming years.
It is my contention that investors have enjoyed the relative calm and safety of a supervised public swimming pool. What they don’t appreciate is that the public swimming pool is to be replaced by the ocean and the forces of Mother Nature. To add further risk to this scenario, the lifeguards on duty (central bankers) couldn’t stay afloat in a bathtub.
Unless you were an investor during the 1930’s, it is fair to assume no one has experienced the sort of turbulence that my theory indicates lies ahead of us.
If we look at what drove the global economy and markets over the past thirty years, we can appreciate why it is unlikely these uplifting factors will exist in the coming years:
- Credit creation on a scale without precedent (see chart below)
- Baby boomers moving through their consumption years
- S&P 500 P/E ratio expanding from 7x to 23x
This massive rise in credit of all shapes and sizes obviously filtered into the broader economy and share markets (see chart of S&P 500 index below).
What we have come to accept as ‘normal’ market behavior is not the least bit normal. We have lived through an extraordinary period of indulgence that has produced a mentality of entitlement.
Baby boomers have a lot to answer for. They created the credit binge that fuelled economic growth that in turn produced higher government revenues that enable politicians to up the pork-barreling ante.
Now the boomers are pulling the pin on credit and wanton consumption which starves government of the revenues it needs to fund the promises the baby boomers demand. Vicious circle.
The power of expanding P/Es also seems to be lost on most investors. An increase in P/E from 7x to 23x gives an investor an automatic 328% return without any increase in earnings.
We know earnings did lift through this period as boomers spent money they didn’t have to buy things they didn’t need, to impress people they didn’t know. This money found its way into banks, retailers, breweries, phone companies etc.
The combination of rising P/Es and rising earnings produces outstanding results.
A company earning $1M on a P/E of 7 = $7M capitalisation.
Company doubles earnings to $2M on a P/E of 23 = $46M cap value – an impressive 657% return due to the rising tides of P/E and earning expansion.
But what has been is not necessarily what is in front of us.
- Demand for credit is falling
- Boomers are retiring en masse for at least the next 15 years.
- P/E expansion is followed by contraction – history is very clear about this fundamental law of physics.
The following chart is the Shiller P/E. Professor Shiller’s methodology smoothes out the earnings data over a 10 year period in order to remove short term volatility. There are critics of this methodology, however for the purpose of long term trend following investment, the graph serves a useful purpose.
Notice how over the 130+ year period the S&P 500 P/E wanders from valleys to peaks. The lowest valley was 4.8x (The Great Depression) and the highest peak was 44.2x (the height of the Tech Boom). The ebb and flow of P/Es is largely a reflection of society’s moods – gloom to boom and all the emotions in between.
Secular (long term) markets are all characterised by the following dynamics:
- Secular Bull Markets start with a low P/E and finish with a high P/E
- Secular Bear Markets start with a high P/E and finish with a low P/E
These are the tides of the markets. Our entire world is made up of yin and yang, left and right, positive and negative, so why is the concept that P/Es can expand and contract such an unthinkable concept to the investing public and industry? This perplexes me.
Are we in a Secular BearMarket? I’ll let someone who is infinitely smarter than I am pass judgement on that. On December 31, 2012, highly respected economic commentator and author John Mauldin wrote in his weekly newsletter Thoughts from the Frontline:
‘We are 13 years into a secular bear market in the United States. The Nasdaq is still down 40% from its high, and the Dow and S&P 500 are essentially flat. European and Japanese equities have generally fared worse.‘(Emphasis added.)
The following chart of the S&P 500 shows two things:
- The massive ramp up in value from 1980 to 2000 – Secular Bull Market
- The saw tooth pattern of the market since 2000. Two distinct falling periods and two rising periods. Each have largely offset the other and produced a very modest gain over the past 13 years – Secular Bear Market
This ladies and gentleman is what secular bear markets do; they correct the excesses of the Secular Bull Markets that precede them.
There are two problems as I see it:
- The US Secular Bull Market of 1982 to 2000 was by far the largest in history. Therefore the corresponding correction should be the largest in history. But to date it hasn’t been.
- The natural correcting forces of the current Secular Bear Market are being fought every step of the way by central bankers. Firstly Greenspan’s sustained low interest rate policy in 2003 that fuelled the subprime lending debacle. Secondly the post-GFC escalating stimulus experiments of QE1, 2 & 3.
Looking at the previous Secular Bear Market of 1968 to 1982 (see chart below) there were nine distinct fall & rise phases (dark and light shaded periods) – five down and four up.
So far the 2000 to 2013 US Secular Bear has had only four phases.
The other worrying aspect is the current P/E of 23x is the same level at which the previous secular bear market started, NOT finished (look at the Shiller P/E chart again for the 1968 ratio).
The other dynamic mulling around in my top paddock is what happens to the ‘supply and demand’ equation of shares as baby boomers look to access their capital to fund their retirement?
As boomers revert from superannuation contributors to retirement pension recipients, will a greater supply of shares for sale dampen prices? Not sure on this one, but one thing is for sure and that it’s a dynamic that has never been ‘experienced’ before.
OK adding (or subtracting) all this up, how do we get to a possible 90% fall in share markets?
Just as we saw how P/E expansion and increased earnings can accelerate an investor’s rate of return, the opposite also holds true.
P/E contraction and reduced earnings is a reverse gearing equation.
Company earning $2M on a P/E of 23x = $46M
Company earning $1M on a P/E of 4.8 (the lowest level recorded) = $4.8M
Can earnings fall in half? Maybe. US earnings in recent years have been inflated by:
- Share buyback schemes (reduced number of shares to divide the earnings over)
- Drastic cost cutting measures
- Wage freezes (something like 70% of US workers have not had a pay increase for 5 years).
My theory is the next global financial crisis will be a sovereign debt default. No major country in the world is paying down debt. Each and every day they continue to add to their debt sand piles.
Some of those piles are becoming awfully unstable. Which pile topples first I have no idea (it is probably one that is not on anyone’s radar screen). But when it does, watch out for the contagion effect.
These are the forces of Mother Nature (or the irrefutable laws of economics) that I think are going to hit markets so hard they will make your head spin.
If they do hit, then yes earnings can fall and fall hard. Consumers bunker down to hold on to what they have. They re-learn the art of thrift (the opposite force of credit fuelled consumption) in an attempt to re-build depleted capital.
So there is my case for a possible 90% correction in markets. If you have another look at the S&P 500 chart you’ll see the two down phases since 2000 have been in the order of 45% to 50%.
Even if the 90% correction is avoided, another down phase in the region of 50+% is certainly well within the realms of being possible.
As to having good Professional Indemnity cover – if markets only fall 50% and not 90%, then sue me for saving you half your capital.
for The Daily Reckoning Australia
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