Let’s first begin by acknowledging that the stock market is up more than 50% in value since 2016. Trump after his election gave the market what it wanted, short term stimulus in the form of tax cuts. Meanwhile, corporate profits before tax have barely improved. What has “improved” is our willingness to pay more per dollar of earnings: valuation multiples have expanded. We are paying more for the same thing – and we are pricing stocks as if there will never be another slowdown again. The problem is the data suggests otherwise…
So why be bearish now? What makes us think valuation multiples will normalize (mean revert) any time soon?
Let’s look at the economy. The stock market (equities) do not respond well to slowing growth and/or recessions (earnings recessions or economic recessions). First we have employment growth slowing and possibly turning negative in 2020 as the following shows. Business investment is slowing as well and is ISM a leading indicator of that as well.
Next, we are seeing railcar loads and trucking slowing materially – also indicating a slowdown in progress. Over the last two months there have been roughly 10,000 jobs lost in the industry, wages are plummeting and we are seeing a significant uptick in bankruptcies.
The Dow Jones Transport index has often been considered a leading indicator of the economy and often the stock market as well.
Here you can see the Transport index in orange diverging from the S&P500 over the last year.
Payrolls adding to the validity of this as noted by David Rosenberg recently:
That said, the market does not require an economic recession for equities to mean revert. Even an earnings recession could be the catalyst needed – the market escaped the earnings recession in 2016 almost unscathed, I doubt we get off so easy next time. Also, note that earnings are tracking the market increase closer here than the first chart “corporate profits” – this is for two reasons.
1. Tax cuts – corporate profits above show stagnation but the bottom line has improved due to tax cuts
2. Share buybacks (financial engineering) – In the world of publicly traded equities the be all and end all is earnings per share. Corporations are quite happy to buy their own companies back at the highest valuations they’ve ever experienced in order to improve their “earnings per share” number which market participants love to fixate on. Now imagine owning a business yourself and buying out your partners at the highest valuation level ever, would you not be wiser to buy your company from your partners when they’re willing to sell it to you at a discount? In the world of public equities we reward management team for overpaying for their own stock.
What happens to equities in a profit recession (historically):
Where is the evidence? >>
Commercial and Industrial loans to businesses are contracting, read: businesses are not investing which means less growth going forward.
We have seen contraction in the manufacturing sector and the data continues to weaken (most notably throughout 2019): (data: 361 capital)
The yield curve is starting to turn positive once again. Of course, there has been plenty of talk about the yield curve forecasting a recession however when it turns positive from a substantial period of inversion that’s usually around the time a recession is beginning or about to begin.
Inversion then steepening >>
The NY Fed produces a related estimate of recession probability as seen below. Note that once we cross the 30-40% range there is usually no turning back.
Some of the big negative catalysts to drive a sharp equity market reaction once a correction begins:
Huge amount of (barely) investment grade debt that could get downgraded causing borrowing rates for those entities to increase.
More generally credit spreads starting to increase eating into profits which to date have benefited from historically low borrowing costs.
As borrowing costs increase we begin to find out which “zombie” companies are not viable without access to plentiful and cheap credit.
Revenue growth slows as consumers reign in spending as consumer confidence wanes.
Consumer confidence in Canada, in particular, is incomprehensibly high given household debt levels and debt service ability of the consumer.
Negative feedback loop, where inflated asset prices have driven the consumers ability and willingness to spend. When that slows, revenue and profits slow, affecting the valuation of companies as analysts have to adjust growth expectations downward rapidly affecting company valuations.
Many assets are benefiting from the extrapolation of “good times” more or less indefinitely. A company’s value is massively inflated with the assumption of above average growth and lower and lower discount rates.
Repo market issues – though perhaps not terribly important themselves they are symptomatic and instructive of what we might experience in a liquidity crunch. Currently, on the surface there are no material issues so why the repo market is having funding issues in this environment does not in still confidence that there won’t be major issues should we financial conditions more broadly deteriorate.
Underfunded pensions becoming even more under funded as asset prices decline and rates fall further increasing the carrying cost of liabilities on corporate balance sheets.
Technical issues will likely be the fact that so much passive money is parked in ETFs, with fewer advisors (in $ terms) overseeing that money. When there is a market event, a panic, retail investors will be in a place where they need to decide if they can continue to hold through a significant drawdown. The value an advisor often presents is the ability to coach a client through a drawdown, encouraging them to hold through the trough rather than being a panic seller at the worst possible time. As such, this time around we may very well have a wave of retail sellers coming in as sellers later into the correction than in past times. Further, more retail money than ever is parked in ETFs and more specifically equities. Retirees have imprudent amounts of money parked in “safe” dividend paying stocks that will challenge their resolve to hold through a downturn. I fear this group will be hurt most in a potential equity market correction.
None of this even speaks to the fact that valuations are exorbitant. Comparable to perhaps only the years 2000 and 1929. John Hussman, can succinctly illustrate the specifics of the bubble we’re experiencing and does even make some rather specific predictions about the magnitude of the correction that would bring us back to normalized valuation levels. Suffice to say, he is of the belief that there is a lot of downside.
I’ll leave this discussion with a quote or two from Stanley Druckenmiller:
“Talk about a crazy priced market […] the credit market, since 1880s or 1890s this is the most disruptive economic period in history. There’s hardly any bankruptcies, […] there are probably so many zombies [companies] out there and there’s going to be some level of liquidity that triggers it.” – RealVision interview
Stanley Druckenmiller, perhaps the world’s best investor during his tenure managing external funds:
“[…] other than P/E’s, and that’s because margins are at an all time record, we are at the top of the valuation run anywhere you look – at least against interest rates.” September 2018