Many stock markets are only marginally off record highs and yet
there's already a growing chorus of calls for a larger correction
or crash. Comparisons to 2008, 1999, 1987 and 1929 are all the
rage. The Internet can be partially blamed for this "noise," as
financial bloggers revert to sensationalism to get attention amid
the cacophony of market commentary. But it also speaks to the
enduring psychological damage to investors from the 2008 financial
crisis. Fears that every correction will result in a crash remain
front of mind.
The market pullback has certainly let the bears come out to
play. Well-known commentator, Marc Faber, A.K.A. Dr Doom, appeared
with a twinkle in his eyes to declare a likely re-run of 1987, but
worse. Faber suggested the S&P 500 would fall 30% this year.
The only problem is that he's been talking of a market crash for
more than two years and it hasn't happened (see
Henry Blodget of Business Insider also reiterated his less
precise, albeit more dire, market call
. He thinks the U.S. market could drop up to 50% over the next 1-2
years. He bases this on expensive valuations, all-time high
corporate margins which are likely to mean-revert and Fed
tightening effectively taking away the punch bowl.
We believe Blodget makes a number of valid arguments and could
end up being right. But he's way too early with the call. And the
principal reason is that history shows Fed tightening has been
bullish for stocks, at least initially. Today's newsletter will
explore Blodget's views in detail, the holes therein as well as the
more plausible risk to markets in the short-term: a deflationary
bust precipitated by Japan and/or China.
A Blodget crash
Henry Blodget is the renowned CEO and Editor of Business
Insider, the financial news website. He's more famously known as
the former equities analyst who made some big buy calls on bubbly
Internet stocks in the late '90s. He was banned from the securities
industry for private emails which conflicted with the bullish
advice that he was providing clients.
In recent months and again this week, Blodget has made the case
that a major market decline of up to 50% is likely over the next
1-2 years. There are cynics who suggest that Blodget is trying to
make up for his lack of caution as an analyst. There may be a grain
of truth to that but it's not our immediate concern.
Your author will instead focus on Blodget's considered and
thoughtful arguments. Blodget says there are three reasons why the
U.S. stock market is vulnerable to a severe correction:
1) Stocks are very expensive.
Blodget primarily relies on the cyclically-adjusted Shiller price
to earnings ratio ((
)). This ratio differs from a normal PER as it takes the average
earnings, adjusted for inflation, of the past 10 years. This seeks
to smooth out business peaks and troughs.
Anyhow, the Shiller PER currently sits at 25x, way above the
historical average of 15x. It's only been at these levels twice
over the past century, in 1929 and 2000. We all know what happened
in those years.
And if you don't believe the Shiller PE, Blodget says there are
a host of other valid methodologies which point to significant
market over-valuation. The below chart shows the average return for
the next decade forecast by these methodologies is just 2%, well
below the historical average 10% returns of the S&P 500.
Therefore, even if there isn't a crash, you can expect poor returns
from U.S. equities going forward.
2) Record-high corporate margins should
Blodget acknowledges that the current S&P PER of 15x is in line
with the long-term historical averages. However, he says this is a
distortion caused by current high profit margins. These margins are
far above anything seen in the past. Notably, these margins almost
always mean-revert. And that means they're likely to be heading
down, impacting earnings and ultimately valuations.
3) Fed tightening has often been bad for stocks.
Blodget's final point is that history shows rising interest rates
have normally preceded significant market corrections. Given the
Fed has forged ahead with QE tapering and foreshadowed a rise in
rates from next year, that doesn't bode well.
Holes in the argument
Let's tackle the argument one-by-one. To the first point, I
agree that the U.S. market is overvalued. From a global standpoint,
it's one of the few big markets which appears pricey. The likes of
Asia are cheap in comparison, perhaps for a reason.
Yes, the Shiller PE has its critics. They point to the ratio
only indicating market under-valuation 2% of the time over the past
two decades, making for a dubious methodology. I doubt this
invalidates it but just indicates that the S&P 500 has been
mostly expensive over that time frame.
It's also important to note that other valuation methodologies
which suggest a similar levels of over-valuation, such as Tobin's
Q, have received much less criticism. Tobin's Q, in particular, has
been proven robust.
To the second point, Blodget overstates the case. Yes, U.S.
corporate margins are at record highs, but not to the extent he
would have it.
The recent lift-off in margins is partly due to an accounting
quirk. U.S. corporations have been earning more from overseas (40%
of total). Foreign sales are included in the corporate earnings/GDP
ratio but costs are excluded. This effectively means overseas
operations are treated as earning 100% margins.
As the blog,
, points out, if you remove this accounting quirk, corporate
margins aren't so wildly elevated. Critically too, there are long
periods such as 1947-1967, where margins stay high, i.e. they don't
mean-revert as readily as many suggest.
Another critical point is that margins have historically peaked
an average 21 months after wage growth has picked up. And the wages
component of the Employment Cos Index is broadly flat at
In my view though, the third point of Blodget's argument is the
most problematic. Blodget suggests that Fed tightening has
typically been bad for stocks. That's not quite right. In fact, the
early stages of interest rate rises have been positive for stocks
on most occasions, as the below chart from Ken Fisher shows.
At no stage over the past century has the S&P 500 peaked
prior to or after the first rate rise. Moreover, cyclical bull
markets have been one-third the way through when the first rate
increase occurs. Market peaks have been reached three years after
the initial rate hike, on average. The shortest lag between first
rate increase and market peak has been one-and-a-half years in the
Typically, the Fed has been slow to aggressively hike rates to
tame inflation, and tightening together with a slowing economy has
led to recession.
Given the Fed won't start raising rates until next year at the
earliest, history would suggest the market may not peak for another
two-and-a-half years at a minimum. And that makes Blodget's
forecast of a market crash improbable.
A secular bear?
To be clear, that doesn't completely rule out a market crash at
this juncture. Anything can happen. However, it does make it more
likely that the current pullback will prove a correction before the
market grinds higher. And a more serious correction lays down the
track. At least that's what the history books tell us.
Blodget doesn't say it but his call bears the imprints of a
secular bear. His crash forecast effectively suggests that we may
be heading into the final stages of a secular bear market. Secular
bull and bear markets are long cycles of rising and falling
markets. Cyclical bull markets can occur within secular bear
markets and vice versa.
The average bear market in the U.S. over the past century has
lasted 18 years. There's a view - to which I subscribe - that the
U.S. entered a bear market in 2000. And that bear market hasn't yet
Mind you, there's lots of different opinion on this issue. Some
think the bear market ended in 2009, making it the shortest of any
bear market of the past 100 years. Others believe the secular bear
market only started in 2009 and therefore we have a way to go.
What is beyond dispute is that PERs, not earnings, drive secular
cycles. During secular bull markets, PERs often start in single
digits and move sharply higher before heading down during a secular
The interesting part is what drives PERs higher and lower. The
answer is the longer-term trend of the inflation rate. Moving from
high inflation towards lower inflation typically drives PERs higher
and thus markets higher. Transitioning from low inflation to a
period of high inflation or deflation normally drives PERs lower,
and markets lower too.
Why do these things happen? Well, when inflation and interest
rates are high, investors want higher returns and therefore will
pay a lower upfront price for stocks. When there's deflation,
future earnings and dividends are assumed lower and investors will
want to pay a lower upfront price as well. Conversely, with low
inflation and interest rates, investors are willing to pay a higher
price for stocks, which drives up PERs.
The upshot is that given current low inflation, the risk for
markets comes from higher inflation or deflation. Higher inflation
doesn't become a major problem for markets until it reaches 4%.
Beyond that point, PERs start to significantly decline.
Therefore, a Fed tightening cycle isn't a concern until
inflation hits 4% and we're a long way from that point.
On the other hand, there's the risk of deflation. For Blodget's
thesis to be proven correct, a deflationary bust is the more likely
scenario to make that happen.
The deflationary threat
Deflation is the number one bogeyman of central bankers. While
the U.S. tapers stimulus, Europe is expected to undertake more QE
soon and Japan and China may follow suit.
The risks from Europe, Japan and China simultaneously conducting
further bouts of QE to depreciate their currencies can't be
underestimated. History shows currency wars often lead to trade
wars, which negatively impact global trade.
In this context, we see Japan as the biggest wildcard and
greatest risk. Any objective assessment of Abenomics would suggest
that it's failing. And that could well result in more
unconventional and inherently dangerous policy moves.
The Japanese Prime Minister, Shinzho Abe, took office 17 months
ago with the aim of reflating the country's ailing economy. He's
printed truckloads of money to depreciate the yen in a bid to
revive trade and put the current account firmly in positive
The only problem is that while the yen has fallen more than 20%
against the U.S. dollar, export growth has been tepid and the
current account has markedly deteriorated.
The key issue is that households are being squeezed. Wages are
declining. Savings are earning almost nothing as QE keeps rates
low. Costs are rising too, as the country's import bill has soared
thanks to the lower currency (which makes for more expensive
The lack of domestic spending power is forcing companies to
invest their money in exports. But the global export pie isn't
growing much. That means Japan is having to take a greater piece of
the pie. Greater market share, in other words.
Yet despite the lower yen, Japan isn't gaining share. Put
simply, companies are selling more but at lower prices.
Many sell-side analysts point to the so-called J-curve effect,
where the increase in exports after currency devaluation typically
lags the rise in imports by 12-18 months. Thus they're suggesting a
turnaround in Japanese fortunes is around the corner. Others point
out that imports temporarily spiked in anticipation of this month's
consumption tax hike. Both have these things may hold some truth.
But the J-curve effect, in particular, is unlikely to prove a
long-term solution to Japan's problems.
What's more likely is that you'll see more and more desperate
actions to try to revive the economy. That could lead to a much
lower yen. And that would put enormous pressure on other exporting
powerhouses, such as China, South Korea and Germany. Tit-for-tat
currency depreciations may result.
Of course, the great hope is that Japan will implement economic
reforms to improve productivity, increase wages and lift domestic
demand. Unfortunately, that's been the hope for the past 24 years
and the forces opposing change have won at every turn.
In sum, a market crash as the Fed starts to lift interest rates
seems an improbable scenario. Any crash would likely come from a
deflationary bust instead. But any deflation will be met by even
more stimulus which may serve to delay any economic bust.
The odds favour markets grinding higher for a while yet.
: No positions.
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