Wednesday , 15 July 2020

Yes, Another 50% Correction Is Possible! Here’s Why

…”It is the overall TREND of the market which determines a bull or bear market [and,] currently, that trend is still rising. Such will not always be the case, however, and we may now be in the process of a trend change. I am not talking about a 20% correction type bear market. I am talking about a devastating, blood-letting, retirement crushing, “I am never investing again,” type decline of 40%, 50%, or more.” [Here’s why.]

By Lorimer Wilson, editor of – Your KEY To Making Money! 

[This synopsis of edited excerpts* (1063 words) from the original article (1929 words) by Lance Roberts provides you with a 45% FASTER – and EASIER – read. Please note: This complete paragraph, and a link back to the original article, must be included in any article re-posting to avoid copyright infringement.]

“While we have been carrying a much higher weighting in cash over the last several months, we also still have a healthy dose of equity related investments. Why? Because the longer-term trends still remain bullish as shown below.

The market did break the bullish trend with a near 20% correction in 2016, but was bailed out by massive interventions from the ECB, BOE, and BOJ.

After a decade of Central Bank interventions, it has become a commonly held belief [that] the Fed will quickly jump in to forestall a market decline at every turn. While such…[was] the case previously, the problem [now] for the Fed is their ability to “bail out” markets in the event of a “credit related” crisis. Take a look at the chart below.

In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion and the Fed Funds rate was at 4.2%. If the market fell into a recession tomorrow, [however,] the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to “bail out” the markets today is much more limited than it was in 2008.

…It isn’t just the issue of the Fed’s toolbox. It is the combination of other issues which have all coalesced which present the biggest risk to a substantial decline in the markets.

1. Valuations

a) CAPE Level

One of the most important issues overhanging the market is simply that of valuations. As Goldman Sachs pointed out recently, the market is pushing the 89% percentile or higher in 6 out of 7 valuation metrics.

…How big of a correction would be required to revert valuations back to long-term means? The graph below charts the percentage of time the market has traded at various ranges of CAPE (Cyclically Adjusted Price -to- Earnings – CAPE 10) levels.

Given that valuations are at 30.5x earnings, and that profit growth tracks closely with economic growth, a reversion in valuations would entail a decline in asset prices from current levels to somewhere between 1,350 and 1,650 on the S&P (See table below). From the recent market highs, such would entail a 54% to 44% decline, respectively.

b) Price to Revenue Level

This also corresponds with the currently elevated “Price to Revenue” levels which are currently higher than at any point in previous market history. Given that the longer-term norm for the S&P 500 price/sales ratio is roughly 1.0, a retreat back towards those levels, as was seen in 2000 and 2008, each required a price decline of 50% or more.

2. Demographics…

3. Leverage

Of course, what fuels corrections is not just a change in investor sentiment but an ignition of the leverage that exists through the extension of debt. Currently, leverage is near the highest levels on record which is the equivalent of a tank of gasoline waiting on a match. As I discussed last week: “What is immediately recognizable is that reversions of negative ‘free cash’ balances have led to serious implications for the stock market. With negative free cash balances still at historically high levels, a full mean reverting event would coincide with a potentially disastrous decline in asset prices as investors are forced to liquidate holdings to meet ‘margin calls.’

Of course, the key ingredient is ownership. High valuations, bullish sentiment, and leverage are completely meaningless if there is no ownership of the underlying equities. The two charts below show both household and corporate levels of equity ownership relative to previous points in history.

As can be clearly seen, leverage fuels both halves of the full market cycle.

  • On the way up, increases in leverage provide the capital necessary for accelerated share buybacks and increased speculation in the markets. Leverage, like gasoline, is inert until a catalyst is applied.
  • It is the unwinding of that leverage that accelerates the liquidation of assets in the markets causes prices to plunge faster and further than most can possibly imagine.

It has only happened twice…since the turn of the century, and both reversions of that leverage resulted in 50% declines.

4. Momentum

Another key ingredient to rising asset prices is momentum. As prices rise, demand for rising assets also rises, which creates a further demand on a limited supply of assets increasing prices of those assets at a faster pace. Rising momentum is supportive of higher asset prices in the short term. However, the opposite is also true.

The chart below shows the real price of the S&P 500 index versus its long-term Bollinger-bands, valuations, relative-strength, and its deviation above the 3-year moving average. The red vertical lines show where the peaks in these measures were historically located.

…What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe.

There are many factors that can, and will, contribute to the eventual correction which will “feed” on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages. The biggest risk to investors currently is the magnitude of the next retracement. As shown below, the range of potential reversions runs from 36% to more than 54%.

That can’t happen you say? [Well,] it’s happened twice before in the last 20 years and with less debt, less leverage, and better-funded pension plans. More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history, which suggests that a mean reversion will be large as well. It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession but, considering we are already pushing the longest economic growth cycle in modern American history, such a risk…should not be ignored…

The next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years.

(*The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.)

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