Is the U.S. stock market poised to crash in 2016? Absolutely. The writing has been on the wall for ages. It’s not as if anything has happened of late to point to a stock market crash, it’s just that the rest of the investing community is waking up to what we have been pointing out for years.
Stock Market Crash Getting Warmed Up
The stock market is supposed to be a barometer of how well the broader U.S. economy is doing. The stock market is a forward looking indicator. So, in theory, the stronger the stock market, the stronger the U.S. economy.
And by all accounts, the U.S. economy is doing great! Since bottoming in March 2009, the NASDAQ has soared more than 250% and the NYSE is up 130%, while the S&P 500 has gained 182% and the 30-company-strong Dow Jones Industrial Average is up more than 145%.
But that’s a little misleading. Those gains were fuelled by income-starved investors clutching at cheap money dangled in front of them by the Federal Reserve in the guise of multiple rounds of quantitative easing. This led to lower interest rates and the need for investors to pour more money into the stock market.
Seven years later, the stock market is still trending near record levels. This is in spite of years of underwhelming corporate earnings and revenue growth-or a lack thereof. Companies can only prop up their earnings by cutting costs for so long. And fickle investors can only prop up share prices for so long.
Eventually valuations have to be in sync. The only way that can happen is if investors wait patiently for that to happen. After seven years of easy gains, I doubt investors will wait in the pits. The other option? Investors will get scared and run for the exits, sending stocks reeling.
After years of being on fire, there are indications that this is starting to happen. Since the beginning of 2015, the once high-flying NASDAQ is down almost five percent; the NYSE has lost 11.5% of its value; the Dow Jones is down slightly more than 10%; and the S&P 500 is 8.5% in the red.
Interestingly, the 12-month average level of the S&P 500 has fallen for two straight months. That has only happened twice since 1995: ahead of the dot-com crash and the 2007-2009 bear market. (Source: Bloomberg.com, September 30, 2015.)
Corporate Earnings and Revenues Deteriorating
The deterioration in the stock market is a reflection of falling revenue and profits and the inevitability of higher interest rates courtesy of the Federal Reserve. Not the trifecta that Wall Street is looking for.
Let’s go back in time a little during the halcyon days of yore. 2013 was a fabulous year for the broader stock market; a year in which the S&P 500 soared approximately 30%. Sadly, that increase did not come on the heels of strong earnings and revenue, it was because quarterly results were not as bad as first predicted. And wide-eyed investors rewarded companies for avoiding a worst-case scenario.
In each successive quarter of 2013, a larger number of companies revised their earnings guidance lower. Yes, normally you’d hope for higher. During the first quarter, 78% of S&P 500 companies that provided preannouncements issued negative earnings guidance. That number climbed to 81% in the second quarter, a record 83% in the third quarter, and a new record 88% in the fourth quarter.
With interest rates at zero, the stock market was the only game in town. And investors played it hard and with reckless abandon.
Fast forward to 2015 and little has changed. Thanks to downward revision to earnings, the estimated year-over-year decline for the third quarter is 4.5%; higher than the expected decline of one percent at the start of the quarter. If the index reports a decline in earnings in the third quarter, no matter how small, it will mark the first back-to-back quarter of earnings decline since 2009. (Source: Factset.com, last accessed September 29, 2015.)
Estimates for third-quarter revenue are equally abysmal at -3.3%. This is also higher than earlier projections of a year-over-year decline of 2.5% at the start of the quarter. Just like earnings, if this holds, this will mark the first time the index has seen three consecutive quarters of year-over-year revenue declines since the first quarter of 2009.
Looking ahead, overly optimistic analysts who don’t know the price of a loaf of bread see earnings growth returning in the fourth quarter of 2015 along with record level EPS. And they project revenue growth in the first quarter of 2016.
Unless of course, it’s cold in the January to March period, in which case they’ll blame missed projections on the weather. Even in California.
Stock Market Wildly Overvalued
The stock market is only as strong as the underlying stocks. So is it a real surprise that the stock market is wildly overvalued?
The oft quoted Case Schiller CAPE/PE Ratio of the S&P 500 is overvalued by around 62.5%. Currently sitting at 23.96, the 10-year average is 15. For every $1.00 of earnings a company makes, investors are willing to pay $23.96. The ratio has only been higher three times: 1929, 2000, and 2007. Each time it was followed by a collapse in the stock market. (Source: Yale University, last accessed September 29, 2015.)
Warren Buffett’s favorite indicator is the Market Cap to GDP Ratio, which, as the name implies, compares the total price of all publicly traded companies to gross domestic product (GDP), the implication being that stocks and their valuations should bear some relationship to the benefits of investing or not investing.
A reading of 100% suggests U.S. stocks are fairly valued. The higher the ratio is over 100%, the more overvalued the stock market. Conversely, the lower the ratio under 100% the more undervalued. The current reading is 123.6%. The ratio has only been higher once since 1950, in 1999, it was at an eye-watering 153.6%.
A variant of the Market Cap to GDP Ratio is the Wilshire 5000 to GDP. The Wilshire 5000 is a market cap weighted index of all stocks actively traded in the U.S. Despite the grandiose 5000 number, the index contains around 3,690 components. This variant is currently at 124.2%. Since 1970, the ratio has only been higher once; in 2000, when it stood at 136.5%. (Source: Stlouisfed.org, last accessed September 30, 2015.)
Buffett’s two indicators suggest today’s markets are at lofty, unsustainable levels; and that the U.S. economy is not doing nearly as well as we’re led to believe. And it’s only going to get worse.
Rising Interest Rates Shock Global Markets
The U.S. stock market is not an economic island. And U.S. companies are relying more and more on foreign countries for growth. In fact, the percentage of sales from foreign countries for S&P 500 companies has increased for the last five years; to 47.82% in 2014 from 46% in 2009. (Source: spindices.com, last accessed September 22, 2015.)
But because the global economy is doing so poorly, S&P 500 companies will have to look elsewhere to pick up the slack. Global stock markets are being routed by growing fears for the global economy and a slump in commodity prices. Despite increasing consumer confidence, global markets are at a two-year low.
The International Monetary Fund (IMF) has sounded the alarm, warning of a possible new financial crisis. Especially in emerging markets, when central banks start to raise interest rates. The U.S. is to make its first move later this year.
That’s bad news for emerging markets anchored to American borrowing rates. Rising global interest rates could usher in a new credit crunch in emerging markets as businesses awash in cheap money (debt) are pushed to the limit.
The debt of non-financial firms in emerging market economies quadrupled from $4.0 trillion in 2004 to over $18.0 trillion in 2014. The ongoing result? Business debt as a share of economic output has soared from less than half in 2014 to almost 75%. (Source: imf.org, last accessed September 29, 2015.)
China has led the charge to higher debt followed closely by other emerging economies including Turkey, Chile, and Brazil-all of which are vulnerable in a higher interest rate environment.
Emerging markets are wholly unprepared to meet higher borrowing costs. And the world could experience a new rash of corporate failures. Just as it did in the U.S. (and still could), local banks who bought much of this new debt could tighten lending, putting a halt on potential growth. For a case study, consider the U.S. credit crisis of 2008-09.
Corporate stagnation could spill over to the financial sector as banks continue to reign in lending. This translates into reduced economic activity and ongoing losses to the financial sector.
Easy monetary policies might be advantageous to advanced economies, but the same cannot be said for emerging markets. In fact, rising interest rates in the United States could unleash an unforeseen economic crisis trilogy that started in U.S. mortgage markets, spread to the eurozone, and is heading to emerging markets. (Source: theguardian.com, September 18, 2015.)
That doesn’t mean advanced economies are in the clear. Borrowing has risen fastest in sectors most vulnerable to an economic downturn, including oil and gas and construction.
A Global Stock Market Crash in 2016
Indeed, the Federal Reserve’s easy monetary policy that was supposed to kick-start the economy has left the U.S. stock market wildly overvalued. On top of that, cheap money translated into an unprecedented borrowing binge from companies around the world most susceptible to an economic downturn and rising interest rates.
In the midst of a weakening global economy, stagnant wages, and non-existent savings, an increase in interest rates from zero to historical levels near three percent could cripple huge portions of the U.S. and global economies and stock markets around the world.
In 2016, interest rates will start to rise, cobbling cash poor Americans; negatively impacting corporate America, earnings, and share prices. Rising interest rates in the U.S. also have the potential to dismantle companies in emerging markets and seize up growth in places like the eurozone, Japan, and China.
What can central banks do to help combat the next downturn besides lower interest rates? Not much. And as we’ve seen, even that hasn’t helped.
The U.S. stock market has been living on borrowed time. And it’s time for payback. 2016 could very well be the year the U.S. stock market collapses.