The Conditions For A Stock Market Crash Are In Place
Predicting a Stock market Crash is impossible…
But assessing the risks and analysing if the prevailing conditions could lead to a crash should be part of the analytical process of any money manager.
We are not predicting a crash in Western equities, despite our bearish views, but we are clearly worried that its possibility cannot be excluded.
As money managers who have have lived through the 1987 crash, the 1989 Japanese equity crash, the 1990 emerging market crisis, the 2000 dot.com bubble and the 2008 Great Financial Crisis, we can recognise some of the advanced signals and know that crash come un-announced..
They just unfold when the market psychology reverses brutally, most of the time, triggered by a single and unexpected event.
In this article we analyse the current situation, draw a parallel with the 1929 crash and highlight the main risks that we see on the horizon.
For anyone who takes a bird’s eyes view of the world we are living in, the disconnect between western equities’ valuations and the macro-economic, financial and geo-political dynamics at play is striking…
And the similarities with the period of the 1920s, the causes of the 1929 crash and its consequences are also striking.
Between March 2009 and December 2021, US equities have experienced the longest, sharpest and most extended bull since the Great Depression. In the matter of 12 years, the SP500 rose from 666 to 4’808, a sevenfold increase while the Nasdaq Index rose from 1’377 to 16’212 multiplying its value by 11.77x.
This spectacular rally was fuelled by a once-in-a-lifetime valuation expansion phenomenon that saw the Nasdaq’s PE ratio rise from 14x earnings to 54x earnings at the peak.
The rally was powered by two main factors, the digital revolution that gave birth to a handful of winner-take-all companies that changed the way we live, communicate and access knowledge on one hand, and extraordinarily unorthodox monetary policies that artificially tweaked the price of money through zero-interest rates policies and quantitative easing that flooded the western economies with liquidity that Main Street did not need.
This excess liquidity, further amplified during the COVID era, found it way into asset prices, sending equities flying, real estate prices surging, created speculative bubbles in meme stocks, SPACS and cryptos and finally led to a massive resurgence of inflation that was amplified by the impact of the war in Ukraine on commodities supply chains.
Moreover, more than a decade of ultra low interest rates have led to an unprecedented accumulation of debt globally.
We accurately predicted and timed the 2022 bear market in bonds and equities, and from January 2022 to Cotter 2022, both asset classes delivered the most negative return in decades.
Since October 13th 2022, our projected bear market rally in equities extended into the first quarter of 2023, powered by a handful of technology stocks in the US and taking the European indexes to near all-time highs as the US dollar depreciated and some late cycle industrial sectors delivered strong tail-end results.
Today, Western equity valuations are at RECORD HIGHS as investors, particularly retail investors, are betting on a quick taming of inflation, a peak in interest rates, and discarding the sharp decline in corporate earnings as a passing phenomenon.
Investors and analysts are bullish, not on the whole market, but on a concentrated group of companies that capture their imagination – Tech in the US and Luxury in Europe – making the market conditions even more susceptible to a sharp decline when they suddenly change their mind or see their hope disappointed.
Since October 2022, 6 months ago, these high flying stocks have risen by 50 % to 100 %, despite sobering economic news, rising interest rates, inflation still grinding up, a major banking crisis, dangerous budgetary dynamics and the sharpest contraction in earnings seen in more than a decade.
But the Q1 reporting season is already giving signs that a turning point in psychology could be at hand.
TESLA may have sold a record number of vehicles in Q1 2023, but its latest results show earnings that have fallen by -21 % when compared to the same quarter of the previous year, as costs have been rising and selling prices have been cut by 29 % in 3 months to maintain volume sales and market share.
NETFLIX may have positively surprised, beating marginally heavily marked down expectations, but its Q1 earnings were down -18 % when compared to the same quarter of last year, with new subscriptions missing estimates and coming primarily for Asian and Emerging markets where pricing and making are far lower.
Sustaining the 40x PE ratio reached agin after its 122 % advance of the past nine months will be difficult.
AMAZON, MICROSOFT, APPLE will report in the coming days, but the same causes will lead to the same disappointments in an environment where worldwide PC sales have declined by 28 and 29 % year on year on both Q4 2022 and Q1 2023. Inflation and record high mortgage rates are taking their toll on consumers purchasing power, corporations are cutting down on investments and laying off staff and the banking crisis is leading the banking system to restrain credit.
The banking sector’s Q1 results are also worrying. Besides a few major banks that have benefitted from the demise of smaller banks and rode successfully the volatility of bond markets, the profitability trends in their core businesses, Net Interest margins, Non-Performing Loan ratios, and loan growth are all painting a dire macro-economic picture.
Unfortunately, most of the indicators we monitor tell us that the US economy is heading into a major economic contraction ahead :
1. M2 Money Supply growth is an advanced indicator of the direction of the economy. It is the main tool of transmission of monetary policy with the economy growing when the rate of growth of Money supply accelerates and economies decelerating when the rate of growth of money supply decelerates. Today, M2 is not only decelerating at the fastest pace ever, but has actually gone into negative for the first time since the 1960s, pointing to a sharp recession ahead.
2. The Yield curve is the most inverted in 50 years. Bond investors are economists by formation. They invest based on their expectations for economic growth, inflation and interest rates levels ahead. Since WW2, every inverse of the yield curve ( short term rates higher than long term rates ) preceded an economic contraction, and this inversion has no equivalent since the 1980s.
3. Real Estate prices are declining. Real estate cycles are well-known and well documented. They are long cycles with typically 7 years of uptrend and 5 years of downtrend. With interest rates kept artificially low for so long, the cycle was entered in both duration and magnitude, taking real estate prices to record highs and affordability to record low. Every decline in real estate prices led to an economic contraction with the latest turn in cvthe cycle leading to the 2008 Great Financial crisis.
5. Bank lending is contracting. With high inflation, high interest rates and the banking crisis, the banking system is retrenching with management optimising their liquidity ratios and tightening lending standards. Even if some of the recent contraction is due to the demise of SVB and the other two us banks that went belly up, the general trend in banks is a downsizing of lending to the economy. In the past, every fall in bank lending had led to an economic contraction
Similarities with 1929
The “Roaring Twenties”, the decade following World War I that led to the 1929 crash, was also a time of surging asset prices and monetary excesses. Building on post-war optimism, rural Americans migrated to the cities in vast numbers throughout the decade with hopes of finding a more prosperous life in the ever-growing expansion of America’s industrial sector. In hose days, the equivalent of today’s technology sector were railroads, automobile, real estate and electricity.
As was the case at the end of the 2010s, despite obvious signs of speculation and glaring overvaluation, equity investors believed that the stock market would continue to rise forever in the 1920s.
However, the American economy already showed ominous signs of trouble by 1927. Steel production declined, construction was sluggish, automobile sales went down, and consumers were building up large debts because of easy credit. Sounds familiar ?
Equity markets had been on a nine-year run that saw the Dow Jones Industrial Average increase in value tenfold, peaking at 381.17 on September 3, 1929.
Then as today, the first warning sign came in the from of a sharp decline declines in the money supply caused by Federal Reserve decisions to hike rates and fight rampant inflation. This monetary contraction had a severely contractionary effect on economic output.
Then as today, real estate prices that had been rising to extremes started turning ahead of the equity markets.
Then as today, investors took the first leg down in equities as a healthy correction and a buying opportunity, as equities recovered over a sixth month period between October 1929 and April 1930, only to turn sharply again afterwards.
Equities then plunged again for almost two years, taking the Dow Jones ( the equivalent of today’s Nasdaq ) down 90 % from peak to through.
It has consistently been our roadmap that we would enter the second leg of the bear market at the time of the Q1 2023 reporting season with an ultimate target of between 2800 and 3’200 on the SP500 by the fall of 2023, as the market narrative evolved form “inflation Fears” to “Recession fears”.
This is where we are today !
But the key question is how fast and how sharply this is going to unfold…
Are the conditions in place for a potential crash ? Indeed they are …
But what could be the trigger for such a drastic event ?
What are the events that could trigger a crash today ?
As money managers and analysts, it our duty to try to identify what could potentially trigger a very sharp sell-off in equities ?
We see THREE GEO-POLITICAL RISKS in order of importance and likelihood
. The use of tactical Nuclear Weapons in Ukraine.
As argued in previous publications, our analysis of the war in Ukraine is that after his major miscalculation the. invading Ukraine on February 2022, Vladimir Putin is now facing a Western world that is waging a proxy war to bring his regime down through the weakening of his military and his own destabilisation internally through sanctions. Seen for the Western side, it is a long lasting war where Ukraine’s military can count on endless financial and technical support to bring the Russian army to its knees over time. Seen from the Russian side, time works against Putin and mots strategic reports point to a situation. where by the ned of the summer of 2023 , his capacity to provide troops and ammunition will be severely dented. Putin now wants an exit strategy, with a peace negotiation where he will aim at keeping the eastern regions of Ukraine and obtain guarantees that Ukraine will never join NATO or the EU. XI Jing Ping’s intervention and proposal for a peace Plan, now relayed by France’s Macron confirm that pressure is building up for an end of the fight and that time is of the essence
Conversely, America, Ukraine and the West refuse to sit at a negotiation table until Russia pulls its troops out of Ukraine, something that Putin will never accept.
To force the issue and bring the parties to the table of negotiations, Putin has few options but to scale up the war and use Tactical Nuclear Weapons against the Ukrainian forces. This amounts to an asymmetrical war that would put the US in the extremely difficult position of chosing between ending the conflict, using Nuclear weapons on Ukrainian soil or engage in a full nuclear war with Russia. The last two options would be devastating for Ukraine, Europe and the world but the initial Russian nuclear salvo would sent hypes asset markets taking, especially in Europe.
Putin is a dictator while the US is a democracy, Putin never does things without reasons and in the past few weeks he has sent nuclear warheads to neighbouring Bielo Russia and stopped providing information on his nuclear arsenal for the first time since the end of the cold war. As was the case in February 2022 when he was amassing troops at the border of Ukraine, dismissing his intentions, potential strategic options and personal resolve would be extremely light.
. Iran’s Nuclear Arsenal
With numerous reports from the Vienna-based International Atomic Energy Agency confirming that Iran is nearing the completion of its program to dispose of nuclear warheads and the return of Benyamin Netanyahu to power in Israel, the possibility of an extensive strike of Iran’s nuclear facilities by Israel in the next six months is increasing sharply.
For Israel it is seen as an existential threat and for the Iranian regime, it is also seen as a question of survival.
And time, here again, is of the essence.
A strike on Iran by Israel would send oil prices shooting up delivering yet another inflationary blow to the Wets6rn economies.at large, and send ng their stocks markets tanking.
A US – Chinese military confrontation in the South China Sea
Neither the US nor China want to go at war over Taiwan. It is in no one’s best interest, it would have devastating consequences for the two countries and the world at large and if China had wanted to invade Taiwan it could have done it may times in the past.
However, accidents are always possible and wars are not always planned.
The dangerous flaming of anti Chinese sentiment in the US will become a major political issue in next year’s US Presidential elections and China will not allow the US to interfere with Taiwan’s own elections. Tensions are rising and the latest demonstration of force by China at the time of Taiwan’s Prudent meeting with US House Speaker Mc Carthy as well as the decision of th US military to send. a destroyer in the Taiwan straights show that neither side is prepared to back down politically.
It would take a very minor accident, miscalculation or error of judgement to spark the Frits military confrontation ever between the militaries of both countries, with the devastating effects that one can foresee on world markets.
But we also see THREE MAJOR ECONOMIC OR FINANCIAL dangers on the horizon
The US Debt ceiling issue
America is already in breach of its constitutional debt ceiling and the US Treasury is using tricks to keep the Government from defaulting until it is resolved. By June 2023, in tow months Tim, Janet Yellen will have used all its creative ammunitions and may have to suspend payments.
The issue is already coming to the fore next week, with the Republican pushing a voter on a plane to solve the problem containing demands that will never be accepted by the Democrats. This blackmailing strategy is highly dangerous as it prevents the Republican camp from backing down in the future while compromising Biden chances of re-elections if he either backs down or allow the US State to default on its obligations.
In a highly polarised political climate where extremism is bound to intensify ahead of next year’s elections, the mere realisation of the possibility of a US default in the coming weeks will have dramatic consequences for the US economy and markets.
A major bank default
The recent banking crisis has revealed the dangerous state of the western world banking system that is carrying massive unrealised losses on its “Hold to Maturity” bond portfolios, the segment of its assets that was supposed to be the safest, most liquid and the best guarantee of solvency.
For now, and with the drastic actions taken by Governments on both sides of the Atlantic to contain the damage, the issue has been somewhat put on the back burner, but as the usb sequent run on Deutsche Bank showed, any event where one of the world’s major bank were to get hit by another Archegos or Greenshill could potentially create havoc and a major domino effect through the humongous amount of interbanking counterparty risks and off balance sheet exposure.
This could happen with a Us bank or a European bank or even several at at time, and neither the banking system nor Governments have sufficient ammunitions left to contain another gReat financial crisis,
Another wave of regional Bank defaults due to real estate
We have highlighted many months ago the risks pertaining to the structure of the US banking system and its thousands of regional or niche banks that are usually focused on one type of credit and have less capitalisation than their major peers.
With real estate prices declining and commercial real estate now showing growing signs of distress, the likelihood of another wave of default is high, and in fact, in our view a quasi certainty sometimes in the the coming two years.
thee real issue here is how large, how contagious and how crippling such a wave will be and what could be its impact on the US banking system and the confidence of US depositors in their own banks. Could it lead to another bank run ?
As can be seen from the above attempt at identifying risks – and very material risks – the possibility of an equity crash CANNOT BE EXCLUDED.
Considering the highly elevated valuations of US and European equities and investors misplaced bullishness, a sharp reversal in sentiment would be devastating for risk assets.
This explains why we have kept our portfolio fully hedged and our short positions in the last rising phase of equities.
But with the release of the Q1 earnings , we are now at a turning point and our readers should be aware of the risks associated with staying invested at current levels
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