Are you ready for the market crash?

The year began with rising uncertainty about the stock market and short term movements in the economy.

While the FED has slowed down its tightening, several risk factors are still around and more and more economic indicators are signaling bad times ahead.

In this article, we are going to see how the yield curve inversion is a strong warning sign, try to make sense of current market valuations and discuss why the high level of debt may represent a systemic risk.

Inverting Yield Curve

The yield curve has proven to be one of the most reliable indicator when it comes to predicting economic crisis and recessions.
Empirical evidence shows how its amazing ability to predict economic downturns, in fact, every time the yield curve has inverted in the past, a recession followed within 6 to 24 months.


Source: Research from Federal Reserve Bank of San Francisco; FRBSF Economic Letter 2018–07 “Economic Forecasts with the Yield Curve”; Michael D. Bauer and Thomas M. Mertens


The yield curve is a relationship between the interest rates of bonds of equal credit quality with different maturity dates. Its information is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates.

The shape of the curve is a pretty accurate indicator for predictions of changes in economic output and growth, that is why you want to pay close attention to its evolution.
If you go on Stockcharts.com, you can find this great interactive tool that allows you to have the Dynamic Yield Curve and monitor its evolution.

As we are approaching the end of the economic cycle, the uncertainty towards the future starts to increase and everyone expects lower economic growth for the coming years.
Interest rates over different maturities start to converge at the same level (e.g. the return that you get for a 2-year treasury and a 30-year treasury are not that different) and the yield curve inverts.

When it comes forecasting economic recessions or making predictions about a future stock market crash, here is what the research from the FED has to say:

A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.”

[…]

While the current environment is somewhat special — with low interest rates and risk premiums — the power of the term spread to predict economic slowdowns appears intact.”

Right now interest rates on US government debt are all converging at 3% an the yield curve is almost flat, and if you check out its evolution over time you can see the tendency to flatten even more.


High Market Valuations

One of the things that you do when you want to assess the economy is take a look at the stock market.

After the 2008 crash and the lowest point reached in 2009, we have been seeing an unstoppable bull market that is going on for almost 10 years.
What are your expectations for future movements of the financial market?

Until the correction of October 2018, many were convinced that it has no place to go but up (thanks also to tax cuts and stock buybacks).
Right now there is rising uncertainty and even tv and newspapers are starting to talk about a slowdown or expecting a bear market in the medium-term.

When you look at current valuations with a long-term perspective, you get an idea of this record bull market and you can realize that maybe this situation is too good to be true.
Here is a summary of the stock market performances from the bottom in 2009 to the top in 2018:

  • S&P 500: +322%
  • Dow Jones Industrial Average: +304%
  • NASDAQ: +527%

This sounds crazy. Why are markets doing so well?
I believe that one of the main reasons for those record performances is the effect of the Quantitative Easing. The availability of easy money, that last time created the housing bubble, this time allowed the stock market to reach record highs, thanks also to margin debt.
More in general, thanks to deficit spending and loans, it was possible to drive economic growth above the level of productivity (that is what ultimately determines sound economic growth), boosting the output in the short-term.
Indeed, while markets grew 300% or more, GDP grew “only” 42% over the same period of time.

The value of a company should reflect its earnings and its growth potential. When you look at earning levels, for the majority of companies they are just above the pre-crisis level of 2008, certainly there was not a three-fold increase in their earnings as there has been a three-fold increase or more in the stock market.

Honestly, do you expect to see other 5 or 10 years of this growth? How long do you expect this to continue? How much stock prices can further increase?

One thing is sure: those trends are not sustainable over the long-term and sooner or later a major correction has to happen.


Debt and Interest rates

After the economic crisis, debt skyrocketed and today its level is extremely high in all of its forms.
This applies to every economic operator, from governments to businesses and consumers.

Loose monetary policy and low interest rates in response of 2008, allowed everyone to be more and more leveraged.
It is not hard to spot the correlation between increasing debt – economic expansion.


As debt increases…

Total Public Debt and Business Debt, source FRED

… GDP follows

USA Gross Domestic Product, source FRED


A huge part of the economic growth in the last few year was made possible by debt.
Governments had to fight the recession with social policies and fiscal stimulus, corporations took advantage of low interest rates to expand their businesses through debt and consumers spent more than they could thanks to easy money and loans.

If you try to focus on the long-term, you can easily realize that debt basically means borrowing from the future, sooner of later it has to be paid back and this will inevitably cause a slowdown in the economy.
But let’s focus on the medium-term: when everyone has high debt that is a factor of risk in the economy because it ties the economic output to credit availability.

Despite the increasing uncertainties, today the economy seems to do well, but when the crisis arrives, things get more complicated.
When everyone is highly leveraged, negative shocks in the economy are amplified and when the possibility to get more debt or refinance the existing stock of debt goes away, the same mechanism that fostered growth now works in the opposite way.

In addition, remember that debt and interest rates are strictly correlated. Although the FED slowed down its tapering, rising interest rates are a threat because given the significant level of debt out there, they act like gravity on economic output.

If interest rates gets higher, interest payments become more expensive, it becomes harder to get loans, bond prices decrease and the overall debt burden may become unsustainable, leading to a strong economic slowdown.

Conclusions

Recent movements in the stock market contribute to rising uncertainty about the evolution of the economy in the short-term.
We can say that the performance of this bull market has been astounding, far beyond economic output (GDP).

Stimulative monetary policy certainly played a huge part in pushing up the stock market and creating those high levels of debt.
While this allowed a bigger output, it increased the vulnerability of the entire economy, exposing it to threats like lower liquidity and rising interest rates.

The yield curve, which is a pretty accurate indicator of economic recessions, tends to invert and the stock market is starting to show first signs of weakness.

What we have been seeing in the last few years is not sustainable over the long-term, I really don’t expect other 5-10 years of this growth that’s why I wouldn’t be surprised to see a major correction over the next months.


This article is for informational purposes only, it should not be considered financial advice.
You can read the full disclaimer here.

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