These Economic Indicators Point to a Possible Stock Market Crash in 2016

Stock Market CrashWill the stock market crash in 2016? That’s a tough thing to predict. That said, there are more than enough leading economic indicators to suggest the stock markets will collapse in 2016. I’m not just talking about the 10% correction investors will shrug off; I’m talking about a crash that could rival 2008.

Stock Market Crash Shaping Up

The last thing the perma-bears on Wall Street are talking about is a stock market crash in 2016. Why should they? The markets are all at or near record highs. The S&P 500 is up more than 215% since the markets bottomed in 2009, while the NASDAQ has climbed a more impressive 290%, and the NYSE has increased more than 160%. The Dow Jones Industrial Average is near record levels, up 175% since March 2009.

Sure, the six-plus-year-old bull market is tired and being dragged higher by exuberant investors; but that can’t go on forever. Already, the markets are showing signs of strain. They aren’t collapsing or correcting just yet. But since the beginning of the year, the stock market has, for the most part, flat-lined, struggling to climb higher.

Lest we forget, the stock markets are only as strong as the stocks supporting them. And right now, the markets are extremely vulnerable.

U.S. Economy Remains Fragile

According to Washington and the stenographers in the press gallery, the U.S. economy is doing great. Unemployment is at a seven-year low of 5.4%, inflation is under wraps, the stock markets are high, gross domestic product (GDP) growth is exuberant, and personal net worth is increasing. What’s not to like?

Unfortunately, there is more to the U.S. economy than simplified headlines. Yes, the U.S. saw 223,000 new jobs in April. That’s the good news. The bad news? April’s job data showed that 6.6 million people wanted to work full-time, but were only able to work part-time due to job unavailability. On top of that, 2.1 million people are not in the labor force, yet have looked for work in the last 12 months. Among that total are 756,000 discouraged workers that have stopped looking for jobs altogether. And finally, the underemployment rate continues to hover near 11%. (Source: Bureau of Labor Statistics, May 8, 2015.)

If the economy is doing so well, why are more than 46 million Americans—14.5% of the population (the same number as in 2012)—still receiving food stamps? Could it be because wages are stagnant and the biggest influx in job creation comes from retail and part-time jobs?

Lower oil prices might be helping at the pumps, but they have also forced cutbacks at many energy companies. And the trickle-down effect is being felt by those companies that supply them.

Also Read: Warren Buffett Predicting Upcoming Stock Market Crash

U.S. Economy Contracting?

The U.S. dollar is strong. But why and at what cost? The why is easy to answer; the U.S. dollar is strong because it’s compared to global economies that are doing so poorly.

For starters, the U.S. Dollar Index is made up of six different currencies: the euro, Japanese yen, British pound, Canadian dollar, Swiss Franc, and the Swedish krona. The euro makes up 57% of the index followed by the Japanese Yen (13.6%). Collectively, these two currencies make up roughly 70% of the index. It’s not hard to see why the dollar is doing so well.

Unfortunately, the strong U.S. dollar and anaemic economy are starting to impact the U.S. economy and corporate profits.

In late April, the Bureau of Economic Analysis announced that the advanced estimate of real GDP for the first quarter of 2015 increased by 0.2%. The world’s biggest economy improved just 0.2% in the first three months of the year. Analysts had projected growth of 1.0%. (Source:  www.bea.gov, April 29, 2015.)

Naturally, most have blamed the slow-as-molasses growth on the bad weather, cheaper oil, and even strikes at West Coast ports—all events that will come to pass. But I think there’s more going on.

U.S. first-quarter GDP numbers would be even bleaker if the inventory build-up component was removed. During the first quarter, private inventories increased by $110 billion; this after growing $80.0 billion in the fourth quarter of 2014. Take out the buffer of private inventories, and first-quarter U.S. GDP was only 0.05%.

First-quarter GDP numbers were also based on incomplete data. Since then, it has been announced that the U.S. trade gap jumped 43% to $51.4 billion; the largest since October 2008 and the biggest percent increase since December 1996. When the trade gap is factored in, we can see that the U.S. likely experienced negative growth in the first quarter. (Source: bea.gov, May 5, 2015.)

First-Quarter Results Dismal

The state of the U.S. economy is being reflected in first-quarter earnings results. And it isn’t pretty.

Of the 360 companies on the S&P 500 (72% of the index) that have reported first-quarter earnings, 71% have reported earnings above the mean estimate. That’s slightly lower than the five-year average of 73%.

Interestingly, while a decent enough number of companies are reporting earnings growth, less than half (46%) are reporting revenues above the mean estimate. That number is well below the one-year average of 59% and the five-year average of 58%. (Source: FactSet, May 1, 2015.)

If the 46% figure stands as the final percentage for the quarter, it will mark the lowest percentage of companies reporting sales above estimates since the first quarter of 2012 (41%). Since 2008, the percentage of S&P 500 companies reporting sales above estimates has only been below 50% six times.

Add it up and the blended earnings decline for the first quarter of 2015 is -0.4%. The future isn’t bright either. For the second quarter, analysts predict a year-over-year earnings decline of -3.6% with revenues to dip even further to -4.4%. In the third quarter, earnings are forecasted at -0.1% while revenues will be down -2.3%. You have to wait until the fourth quarter for earnings to turn positive in this great period of economic recovery. Earnings are expected to be up 5.4%, with revenue increasingly at a paltry 0.3%. (Source: FactSet.com, April 24, 2015.)

Strong U.S. Dollar Hurting Everyone

Will the S&P 500 be able to hold on to gains or reach further highs? The domestic data don’t seem to support the notion of a seven-plus-year bull market. Internationally, it’s even worse. Almost half of all the companies listed on the S&P 500 get earnings from Europe (barely growing), Japan (moderate growth), China (slowing), and even Russia (deep recession).

Toss in a strong U.S dollar and the situation becomes that much more dire. During the first quarter, the U.S. dollar gained relative to the euro. At the end of 2014, one euro was equal to US$1.21. By March 31, the tables had turned and one euro was worth approximately $1.07.

The same holds true for year-over-year values for both the euro and yen. In the first quarter of 2014, one euro was worth US$1.37. In the first quarter of 2015, one euro was, on average, equal to US$1.13. In the first quarter of 2014, one U.S dollar was equal to $102.76 yen. Fast forward one year and one U.S. dollar was, on average, equal to $119.17 yen.

A strong U.S. dollar is great for those with money. But that doesn’t account for very many people. Companies on the S&P 500 will be feeling the effects of a strong U.S. dollar for a long time to come. And earnings will continue to be underwhelming.

Do Stock Overvaluations Rival 1929 and 1999?

Stocks are at record levels. In the right context, that might be worth celebrating. But it’s not.

The CAPE PE ratio for the S&P 500 is based on average inflation-adjusted earnings from the previous 10 years. If the ratio has a value of 27.24; that means, for every $1.00 of earnings a company makes, investors are willing to shell out $27.24. The only times the ratio has been above these heady valuations were in 1929 (Great Depression) and 1999 (Great Dotcom Bubble).

If we compare the current valuation of the S&P 500 to its historical average of 16.59, the stock market is overvalued by roughly 65%. (Source: yale.edu, last accessed May 8, 2015.)

Why is the stock market so overvalued? With interest rates so low, there’s nowhere else for income-starved investors to look. And with the U.S. economy doing so well, why would they? For the bulls on Wall Street and Main Street, it’s nothing but blue skies for the stock market.

During the first quarter, investor optimism swelled 21 points to +69 in February. That represents the highest level since 2007. The 21-point increase is also the biggest quarterly gain in two years. (Source: Wells Fargo & Company, March 5, 2015.)

More than half of investors (58%) said it was a good time to invest in the stock market; up slightly from the 56% at the end of 2014. It is also up significantly from the 52% that said the same thing last July. In 2011 and 2012, most investors conceded that it was not a good time to be in the markets.

Not surprisingly, overly optimistic investors are shunning bearish stock market funds. The Total Asset Rydex Bear Index Fund, which tracks assets in bearish stock market funds, is at its lowest level in more than 15 years. (Source: stockchart.com, data set, “Total Assets Rydex Bear Index Fund,” last accessed May 5, 2015.)

Optimistic Investors Push Margin Debt to Record Levels

I know the bulls will say “it’s different this time,” but I don’t think it is.

March margin debt levels for the NYSE hit a record $476.4 billion. In October 2007, the last record high on the NYSE before the markets crashed, the margin level was $345.4 billion. When the stock markets bottomed in March 2009 (otherwise known as the beginning of the bull market), margin debt was about $182.2 billion. (Source: nyxdata.com, last accessed May 8, 2015.)

Margin debt is when investors borrow stock against the value of their portfolio to gain financial leverage. Meaning, investors are optimistic enough about the markets they are willing to borrow against their future. The current record levels suggest investors see very little risk in the markets. And this is worrisome.

For example, with leverage, an exchange could extend margin requirements whereby an investor could borrow $10.00 worth of stock for every $1.00 invested. If a stock goes up one percent, an investor would make 11%. If a stock goes down, the same holds true. If a stock falls too much, an investor could lose significantly more than their possible investment or even what they own.

And the odds for negative returns over the coming years are pretty significant. Over the last 20 years, the level of margin debt relative to the economy has an 80% negative correlation for the next three years of stock market returns. With margin debt-to-GDP at record highs, investors could, over the next three years, witness a bear market that rivals the 1999 and 2008 corrections. According to one debt-to-GDP projection, returns over the next three years project a negative return of 50%. (Source: Barrons.com, May 6, 2015.)

Will Rising Interest Rates Cool the Bubble?

In a word, no. Most expect the Federal Reserve to begin raising interest rates in September. Currently hovering near zero, interest rates will make a slow, methodical climb over the coming years.

The last thing the Federal Reserve wants to do is upend the so-called economic recovery by shocking people with high interest rates. So if the Fed does raise rates in September, it’ll be by a small margin, to 0.63% or (slightly) above. And if all goes well (according to the Fed), interest rates will rise to over 1.50% by the end of 2016.

The increases will impact the day-to-day lives of the typical cash-strapped American. But those kinds of baby steps will not really do anything to cool the stock market. So while some think rising interest rates will pour cold water on the bull market, I disagree.

In fact, raising interest rates could just buoy investor sentiment higher. After all, rising interest rates mean an improving economy. And you know what that means? Higher corporate earnings and share prices. The bull market party rages on.

Will the Stock Market Crash in 2016?

It’s impossible to time the stock market. But there are enough economic indicators to suggest the U.S. stock market will experience a major correction; one that could easily rival the crash of 2008.

Investors dubious of the U.S. recovery may want to prepare their portfolio for a major pull-back. A balanced retirement portfolio needs to have crash protection. That could include precious metals like gold and silver, Treasuries, and bonds. Investors should also consider blue-chip stocks that have a long history of increasing their annual dividend yield; even during crashes.

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