Stocks Could Fall 80% From Here

Guest Post by Bill Bonner

Like a “Closing Out Sale” that never seems to end, people are beginning to think that this “Stock Market Surge” may not be totally on the level.

Unlike an honest bull market, it may never end…

Classic Top?

But in many ways, it looks more and more like a classic top.

Stocks keep going up… and more and more investors, getting in the mood, think they will go up forever.

The last time we saw anything comparable was at the end of the 1990s.

Then, it was the tech-heavy Nasdaq that had caught fire. It burned hot from 1995 to 2000, with prices up five times.

But then, when there was no more furniture to throw onto the fire, it quickly went cold.

The Nasdaq fell 80%; the ashes remained cold for the next 10 years.

The flames were only rekindled after the Fed and other central banks added $15 trillion to the world’s supply of dry tinder.

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No Ordinary Market

This was one of three incidents over a 20-year period that reshaped popular attitudes to money, investing, and the markets.

First came the “Black Monday” crash of 1987. Then, there was the aforementioned collapse of the Nasdaq in 2000. Finally, the crisis of 2008–09 further drove home the point: This is no ordinary stock market.

Until 1987, the best way to make money in the stock market was to do careful research and find good companies selling for less than they were worth.

After 1987, the value of this kind of fundamental analysis fell. It didn’t matter anymore how much something was worth.

The stock market was no longer functioning as a market for stocks, carefully discovering what each and every one was worth. Instead, it was reacting to something else.

And by 2009, fundamental analysis was no longer helpful; it was, in fact, counterproductive. The more research you did—to identify value-rich companies—the worse your portfolio would do.

This may seem impossible. But that is what happened. Value-rich companies with low price-to-earnings (P/E) ratios and little debt underperformed the go-go leaders of the growth genre.

Mr. Luskin’s Math

This phenomenon was inadvertently described in a recent Wall Street Journal article.

Donald L. Luskin, a macroeconomics forecaster, wrote an enthusiastic editorial in which he argued that stocks may be high, but they are going much higher because “policy changes augur much better earnings in the coming years”:

[A]s in 2009, the economy is facing a fundamental turning point driven by profound changes in economic policy. Once again, it’s policy, not valuations, that is determining stock prices.

Mr. Luskin did the math.

At a corporate tax rate of 35%, a dollar of corporate earnings turns into 65 cents after Washington takes its cut. At the new 21% rate, the same dollar becomes 79 cents. That’s earnings growth of 21.5%.

If we were advising Mr. Luskin, we would suggest he put his calculator down and put on his thinking cap. Out of whose pocket cometh that extra 14 cents?

You will say, “It comes from the tax cut.” But since the feds won’t forego a single penny in spending, we must assume they will get it from somewhere else, right?

Where?

Corporations, as proponents of the tax cut were quick to point out, do not pay taxes. They just collect them. The money either comes from their employees, their shareholders, and/or their customers.

So if the shareholders and/or the employees get 14 cents more, it is almost a dead certainty that the customers will get 14 cents less.

Then who will buy the corporations’ products and services?

(Yes, we are aware of the Laffer Curve… and the theory that there is an ideal tax rate out there at which the feds maximize their income, often by lowering tax rates. But first, there is no evidence that it is true. Second, even if it were true, there’s no reason to think the new tax rate is any better than the last one. And third, it seems unlikely that further stimulus, at this point in the business cycle… after $10 trillion of Fed stimulus since 2009… will produce much of anything… except, maybe, more money for shareholders and corporate insiders!)

Rock Star Central Bankers

So yes… Mr. Luskin could be right… as far as his math and his logic take him.

But transferring wealth to shareholders and bondholders is what the feds have been doing for the last 30 years, ever since former Fed chief Alan Greenspan invented the “Greenspan put.”

By slashing interest rates and talking up the market, Mr. Greenspan guaranteed that stocks wouldn’t go down too much, or stay down too long.

The Greenspan Era represented a fundamental and dramatic turnabout for the Fed.

America’s central bank was meant to be—and had been—a mostly passive institution. Few people knew who the chairman of the Fed was; few cared.

The Fed was not meant to guide the economy… and surely not to enhance it. Instead, it was supposed to only guard against excesses, as former Fed chairman William McChesney Martin put it, by “taking away the punchbowl” when the party got too hot.

But Mr. Greenspan was determined to be a rock star. Instead of taking the punchbowl away, he added more booze!

Stocks went up for the next three decades… as more and more alcohol got dumped into the punch.

And now, look around: The world has $233 trillion in debt. Interest rates are barely off the floor. And as much as $11 trillion of debt trades with negative yields.

So when the current tightening cycle causes the next crash… the feds will panic, as usual.

And, as usual—having learned the lesson over the last 30 years—investors will buy the dip, confident that the feds will come into the market with their cheap sauce.

But this time, the bottles will be empty.

An “Extreme Warning” From Our Doom Index

When we left you last, we were describing why the situation is getting dangerous for investors, and how the lessons learned over the last 30 years may backfire in the next crisis.

“Dow over 26,000… bitcoin under $10,000,” reports the news… “but could crypto panic spill over into stocks?”

Investors are accustomed to depending on the Greenspan-Bernanke-Yellen Put… which is to say, they are pretty sure that the feds will come in with more booze when the party starts to flag.

“Buy the dip,” they tell each other, confident that the feds can be counted on in a pinch.

Many think the recently passed tax bill is 80-proof, too—sure to rev things up by putting more money in the hands of shareholders and consumers.

Maybe it will raise stock prices. Or maybe it won’t. What it won’t do is make the next crisis disappear.

Bad Tidings

We hate to be the bearer of bad tidings, but bad tidings are all we have to bear.

Corporate America is already pretty flush. The price-to-earnings (P/E) ratio for the S&P 500 is now 70% above its long-term average.

In fact, the price of stocks relative to earnings has only been near this high three times in the last 118 years… each time caused by the aforementioned Fed party favors.

And if stocks go higher, it merely gives them further to fall.

In order to get back to more traditional levels, notes Martin Feldstein in a recent Wall Street Journal article, the next bear market would have to wipe out some $10 trillion of stock market wealth.

This, he says, would take 2% off annual GDP… tipping the country into recession.

Extreme Warning

How close is this crisis?

We turn to our Doom Index, put together by our ace researcher, Joe Withrow:

The Doom Index spiked back up to “7” this month – our extreme warning level.

After a surprisingly expansive third quarter in 2017, credit growth fell back to 1.6% in the fourth quarter. Paraphrasing your friend and economist Richard Duncan, bad things happen when credit growth falls below 2%.

Looking at the credit markets, corporate bond downgrades continued to come in at an elevated level last quarter. And junk bonds are starting to show some cracks, falling more than 1% on the quarter. That said, junk bonds still closed out 2017 in positive territory.

Stock valuations are still high relative to their historical averages. But we still haven’t really seen the spike in “animal spirits” that we usually see at the end of each bull market.

But that is starting to change. Investor bullishness spiked by more than 20 percentage points last quarter, as measured by the American Association of Individual Investors survey that we follow.

Our financial metrics were the first to scream warnings at us back in 2000 and 2007… but the markets did not crash until we started to get warnings from our productivity metrics also. I suspect that will be the case this time around as well… But you can never know for sure.

What you can know, however, is that we are much closer to doom today than we were last quarter. Might be a good idea to dust the old Crash Alert Flag off… Make sure it looks presentable.

Inevitable Bear

We’ve hung out the old black-and-blue Crash Alert flag so often—and without effect—that both it and our reputation for market timing are in tatters.

We’re reluctant to expose either to further ridicule now.

But a bear market is inevitable. We recall the 1970s…

It was in 1973 that the Dow first crested above 1,000. Then, it went down… and didn’t get back to 1,000 for another decade.

During that time, the ’70s, “nominal” stock prices—without accounting for inflation, that is—went down, but never by more than about 25%.

The damage didn’t seem so bad. But consumer price inflation was also steadily eating away at “real” (inflation-adjusted) values. You can see what really happened by looking at the Dow in gold terms.

The peak occurred in 1965, when it took about 25 ounces of gold to buy the Dow stocks.

Then, stock prices fell… down… down… down – to the point where you could buy the entire Dow with a single ounce of gold.

In real terms, stocks had lost 96% of their value.

Ready… Aim… Fire!

We see a similar debacle coming. The Dow sells for 20 times the price of an ounce of gold—below the level of ’65, but higher than the level of ’29.

Central banks are raising rates. Inflation seems to be picking up. And the feds have huge deficits to finance.

The bond market is going to be squeezed between more supply and less demand. Bond prices will fall as yields rise. Recently, the yields on the 10-year Treasury rose to 2.58%, up from a low of 1.40% set in July 2016.

Stock prices will fall, either because of rising interest rates… or in spite of them. Expect initial losses of about 50%.

Then, once again, investors will turn their lonely eyes to the Fed.

Ready… aim… fire! The artillerymen at the Fed will give the order. But the shot won’t be heard all around the world. Instead, it will barely be heard at all… because the Fed is out of powder.

As Mr. Feldstein explains, the Fed waited too long to begin raising rates. In a crash, it will want to cut rates. But unless the crisis waits another two years, it will have almost no rates to cut… and no monetary stimulus to offer.

What about fiscal stimulus, you ask—more deficit spending by the government?

Ah-ha… that’s what the tax cut is supposed to be. In effect, while the Fed was too late… Congress fired its cannon too early—even before the enemy appeared on the scene.

And now, when the next crisis arrives, it will be almost impossible to pass another tax cut or spending increase… or finance more deficits… without driving up rates and making the situation worse.