Henry Blodget: “Don’t Be Surprised If This Is The Start Of A Stock Market Crash” – Business Insider

Posted on :Apr 11, 2014

By: Henry Blodget

Business Insider

April 11, 2014

Stocks are tanking again.

The sudden dives in recent weeks have taken the tech-heavy Nasdaq down 7%  from its highs and the S&P and Dow about 3% from their highs.

Drops like that are no big deal.

But some signs suggest that this pullback — or another one sometime soon —  could get much more severe.


Three basic reasons:

  • Stocks are still very expensive
  • Corporate profit margins are at record highs
  • The Fed is now tightening

Let’s take those one at a time.

First, price.

Even after the recent drops, stocks  appear to be very expensive.

The chart below is from Yale professor  Robert Shiller. It shows the cyclically adjusted price-earnings ratio of the  S&P 500 for the last 130 years. As you can see, today’s P/E ratio of 25X is  miles above the long-term average of 15X. In fact, it’s higher than at any point  in the 20th century with the exception of the peaks of 1929 and 2000 (you know  what happened after those).

PEsRobert Shiller, Business  Insider

Does a high PE mean the market is going to  crash? No. But unless it’s “different this time,” a high PE means we’re likely  to have lousy returns for the next seven to 10 years.

By the way, in case some of your bullish  friends have convinced you that Professor Shiller’s P/E analysis is flawed,  check out the chart below. It’s from fund manager John Hussman. It shows six  valuation measures in addition to the Shiller P/E that have been highly  predictive of future returns over the past century. The left scale shows the  predicted 10-year return for stocks according to each valuation measure. The  colored lines (except green) show the predicted return for each measure at any  given time. The green line is the actual return over the 10 years from  that point (it ends 10 years ago.  Today, the average expected return for  the next 10 years is slightly positive — about 2% a year. That’s not  horrible. But it’s a far cry from the 10% long-term average.

Chart of stock market valuationJohn Hussman, Hussman  Funds

So that’s price. Next comes profit margins.

One reason stocks are so expensive these  days is that investors are comparing stock prices to this year’s  earnings and next year’s expected earnings. In some years,  when profit margins are normal, this valuation measure is meaningful. In other  years, however — at the peak or trough of the business cycle — comparing prices  to one year’s earnings can produce a very misleading sense of value.

Have a glance at this recent chart of  profits as a percent of the economy. Today’s profit margins are the highest in  history, by a mile. Note that, in every previous instance in which profit  margins have reached extreme levels — high and low — they have subsequently  reverted to (or beyond) the mean. And when profit margins have reverted, so have  stock prices.

profits as a percent of GDPBusiness Insider, St. Louis  Fed After-tax profits as a percent of GDP.

Now, you can tell yourself stories about  why, this time, profit margins have reached a “permanently high plateau,” as a  famous economist remarked about stock prices in 1929. And you might be right.  But as you are telling yourself these stories, please recognize that what you  are really saying is “It’s different this time.” And “it’s different this time”  has been described as “the four most expensive words in the English  language.”

And then there’s Fed tightening.

For the last five years, the Fed has been  frantically pumping money into Wall Street, keeping interest rates low to  encourage hedge funds and other investors to borrow and speculate. This free  money, and the resulting speculation, has helped drive stocks to their current  very expensive levels.

But now the Fed is starting to “take away  the punch bowl,” as Wall Street is fond of saying.

Specifically, the Fed is beginning to  reduce the amount of money that it is pumping into Wall Street.

To be sure, for now, the Fed is still  pumping oceans of money into Wall Street. But, in the past, it has been  the change in direction of Fed money-pumping that has been important to  the stock market, not the absolute level.

In the past, major changes in direction of  Fed money-pumping have often been followed by changes in direction of stock  prices. Not always. But often.

Let’s go to the history …

Here’s a look at the last 50 years. The  blue line is the Fed Funds rate (a proxy for the level of Fed money-pumping.)  The red line is the S&P 500. We’ll zoom in on specific periods in a moment.  But just note that Fed policy goes through “tightening” and “easing” phases,  just as stocks go through bull and bear markets. And sometimes these phases are  correlated.

1966-2014Business  Insider, St. Louis Fed

Now, lets zoom in. In many of these time periods, you’ll see that sustained  Fed tightening has often been followed by a decline in stock prices. Again, not  always, but often. You’ll also see that most major declines in stock prices over  this period have been preceded by Fed tightening.

Here’s the first period, 1964 to 1980.  There were three big tightening phases during this period (blue line) … and  three big stock drops (red line). Good correlation!

1964 1980 stocks and interest ratesBusiness  Insider, St. Louis Fed

Now 1975 to 1982, which overlaps a bit with  the chart above. The Fed started tightening in 1976, at which point the market  declined and then flattened for four years. Steeper tightening cycles in 1979  and 1980 were also followed by price drops.

1975 1982Business  Insider, St. Louis Fed

From 1978 to 1990, we see the two drawdowns  described above, as well as another tightening cycle followed by flattening  stock prices in the late 1980s. Again, tightening precedes crashes.

1978 1990 bBusiness Insider, St. Louis Fed

And, lastly, 1990 to 2014. For those who  want to believe that Fed tightening is irrelevant, there’s good news here: A  sharp tightening cycle in the mid-1990s did not lead to a crash! Alas, two other  tightening cycles, one in 1999 to 2000 and the other from 2004 to 2007 were  followed by major stock market crashes.

1990 2014Business  Insider, St. Louis Fed

One of the oldest sayings on Wall  Street is “Don’t fight the Fed.” This saying has meaning in both directions,  when the Fed is easing and when it is tightening. A glance at these charts  shows why.

On the positive side, the Fed’s  tightening phases have often lasted a year or two before stock prices peaked and  began to drop. So even if you’re convinced that sustained Fed tightening now  will likely lead to a sharp stock-price pullback at some point, the bull market  might still have a ways to run.

So those are three reasons why the  stock market could experience much more than a garden-variety “correction” —  price, profit margins, and Fed tightening.

None of this means for sure that the market  will crash or that you should sell stocks (I  own stocks, and I’m not selling them.) It does mean, however, that you  should be mentally prepared for the possibility of a major pullback and lousy  long-term returns.

So if the recent stock weakness turns  out to be the start of a major pullback, don’t say you weren’t  warned!

Gold Goliath is not your typical gold dealer.

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