Why A Market Crash Could Be Just Around The Corner

bear-market-bearMy Comments: The prophet of doom strikes again!

No, seriously, the evidence is mounting and the financial pundits are all talking about this. Some of it is the threat of a Trump presidency, which I believe is a real threat. The rest of it is mostly mathematics and economics and history.

If you have money in places where you can control how it’s invested, I encourage you to call someone and have them move it to cash or something similar. While accurately timing the market is a myth, a defensive move on your part for the next six to twelve months could eliminate a lot of chaos in your life.

Oct. 28, 2016 by INVESTIV

Summary

  • We’ll discuss some risks first and then discuss potential rewards.
  • Valuations are the tipping point toward a riskier perspective.
  • After reading this article you’ll be able to decide for yourself what the best strategy is for you to follow.

Introduction
In order to see where the market is going, let us first take a look at what the market has been doing in the last two years. The market has had a 7% yearly return if we look at it from October 15, 2014, however, if we wait a month, the yearly return for the last two years will fall to 1.8% per year. 1.8% a year plus a dividend yield of 2% isn’t bad in the current low yield environment, but it is bad when compared to the risks stock investors are running.

Risks: Where The Market Could Go

As the market is severely influenced by the actions or inactions of the Fed, the first risk comes from an interest rate increase likely to come in December. The market is already preparing for it as 10-year yields are slowly increasing and the dollar is strengthening.

This is a risk for stocks as a stronger dollar lowers international revenues in dollar terms and consequently lowers earnings. Also, higher interest rates and treasury yields will lower the demand for dividend yielders. Since this bull market started back in 2009, the yield spread between the S&P 500 dividend yield and bonds has consistently been around 300 basis points. If yields increase, the S&P 500 is bound to decline in order to continue having a yield advantage which is inherent for the risk premium for stocks.

If the FED increases rates, the risks are high. Unfortunately, if the FED doesn’t increase rates the risks are also high. The FED might not increase rates or may quickly lower them after an increase if the economic and employment situation starts to deteriorate. As we’ll show you in a moment, the economic situation isn’t that great.

The FED looks primarily at three factors: economic growth, employment, and inflation.

Economic growth has been slowing down in the last two years, alongside declining corporate earnings. The estimates foresee improving economic growth of around 2.5% for the next few quarters, but you know how estimates are, made to be missed.

Bad economic news would be detrimental for stocks as it would mean slower growth and lowered earnings, while good economic news would also put pressure on stocks with increased interest rates and a stronger dollar.

On the employment side, things have improved substantially in the last 7 years but similarly to GDP growth, labor market conditions haven’t seemed to improve in the last two years. The Labor Market Condition Index derived from 19 labor indicators has been trending down for two years now and even entered negative territory in 2016.

Inflation has been increasing in the last 12 months which isn’t a good sign if economic activity and labor conditions continue to deteriorate because it will force the Fed to increase rates even though the economics aren’t that good.

All of the above mentioned risks are a normal consequence of economic cycles as there are always things that improve and others that slow down. We can also see this in the current downturn in the oil market. But when these risks are related to current valuations, we can see the real risks low interest rates, a recession, a weaker labor market, and higher inflation create.

As the S&P 500 has a dividend yield of 2.08% and an earnings yield of 4.04%, any significant increase in interest rates would result in a bear market. Similarly, a recession, declining employment or higher wages would push down earnings as well as asset prices.

On top of internal risks, external risks could also have an impact, like fears over China had back in August 2015 and on Thursday when the index was down 1.2% at one point as a result of a decline in Chinese exports.

The main question is, when might the above mentioned risks materialize? Well, forecasting is an ungrateful profession, but I can take an approximate shot at it.

I wouldn’t be surprised if we see a bear market in the next 12 to 24 months as we are currently in an environment without clear indications, the economic growth period already exceeds the average growth period between recessions, and the current economic recovery has been the weakest since the second world war despite the incredibly low rates and quantitative easing.

Let’s attach a 50% probability for a bear market in the next two years, which is a bit higher than J.P.Morgan’s 38% probability, but in line with predictions from Deutsche Bank.

Now that we’ve shown the risks, let’s analyze the potential upside.

Rewards: Where The Market Could Go

A person yelling that the market was overvalued in January 1998 was completely right, but the market went up a whopping 36% in the next two years only to fall by 46% after 2000. Similarly, we can now yell that the market is overvalued, which it is, and then watch it climb to new highs in the next couple of years. Let’s see what the probability and reasons for such a bullish perspective are.

• The Cavalry: The FED will step in at any sign of trouble.

The current bull market is clearly fueled by the FED’s stimulus. If the market shows indications that it will drop or that there is a probable recession, the FED will probably do the only thing it can do, print more money.

• Corporate profit growth.

Unlikely in the case of a recession and with the high competition in business created by the low interest rates, but a recovery in oil prices could push earnings up and consequently the market.

• Tax Holiday: Increased buybacks and dividends due to profit repatriation.

If the government would allow corporations to repatriate the $2.1 trillion in cash stashed overseas at no cost, it would certainly give a boost to buybacks and push stocks higher as managers never think they are overpaying for their own stock. You can read more about this topic in our article here.

• Global economic growth.

As emerging markets are bound to reach the level developed countries have due to improvements in technology, trade, and capital flows, the global economy could push ahead with big strides, especially if commodities rise. This will happen for certain as commodities are a pure cyclical play.

What is the probability of the above happening? Well, faster global economic growth, corporate profit growth, and a tax holiday will all happen eventually, while we don’t know if the FED is going to increase its stimulus to prevent a market decline.

Conclusion

With market risks and potential catalysts being almost equal weight, the tipping point is valuations. Ask yourself if you are happy owning assets that can easily drop by more than 25% for a meager 2% dividend yield, a 4% earnings yield and no earnings growth.

If you are convinced that the stock market is risky, what you can do is invest in uncorrelated assets, lower your exposure to the general market, and have a larger cash position. More cash will provide you with the necessary firepower to buy if there is an eventual market downturn and stocks become much cheaper.

It’s hard to believe but Nike (NYSE:NKE) was trading below $10 a share back in 2009. A bear market will produce plenty of such opportunities so have some cash ready.

Advertisements