I have been predicting a severe stock market downturn for most of the past year. It hasn’t happened yet in spite of the market volatility earlier this year. Instead, the Trump tax cuts have “juiced” the market, making an already large stock market bubble into an even larger stock market bubble! This market has gone from stupid to dangerous!
THE BIGGER THEY ARE, THE HARDER THEY FALL
The above chart shows the S&P 500 from 1990 to present. Note the bull market that began in 2009. It is officially now the longest and largest bull market in US history!
Also shown in this long-term view of the S&P 500 are the two prior bull markets, which themselves were two of the largest in history. Neither ended well, with each one lopping about 50% off the peak valuation of the S&P 500. If the current market were to drop 50%, approximately 13,000 points would be wiped off the Dow Jones Industrial Average! My prediction is it will drop more than 50% due to a coincident economic crash.
STOCK MARKET CRASHES DON’T EQUAL ECONOMIC CRASHES, BUT….
On October 19, 1987, we witnessed the largest single-day stock crash in US history, with the Dow Jones Industrial Average falling 22.6% that day. The market decline started months prior to that day, and finished in the months following, so the total decline was much larger. This crash shook the world of finance, but it didn’t bring it to its knees as happened in 1929. Instead, after consolidating for a handful of months, the bull market of the 1990s ensued and concluded with the tech bubble in the late 1990s.
Economic crashes happen when the banking system fails, due to large numbers of borrowers failing to pay back debt. Excessively loose credit often precedes economic crashes. A little known fact is that the credit markets are over 100-times the size of the stock markets, so when the credit markets sneeze, stock markets get ill.
Today, borrowing on credit is at all time highs, and the risks cannot be overstated. President Trump’s tax cuts have now led to the largest deficits ever in the United States. Student loans, totaling $1.5 trillion, are now considered dangerous debt, with many loans going unpaid. Nobody owns a car anymore. Instead, with interest rates as low as they have been, most people lease their cars. A lease is a form of debt. As for housing debt,…well the housing bubble is right back where we started before the last crisis. Borrowing is at all time highs, and is presenting more risk to the banks than ever!
As long as things are good, and the banks get paid, all appears well. But when the inevitable recession hits, all will NOT appear well, and these risky bets will become more than apparent!
In this day and age, there is yet another market, thousands of times larger than even the credit markets. That market is the derivatives market. This market is valued in the “hundreds of TRILLIONs” of dollars (about $247 trillion to be exact). It is loosely regulated, and little is known what will happen if it begins to implode.
In 1998, a little known hedge fund called Long Term Capital Management, run by John Meriwether out of Greenwich Connecticut, totally surprised the Federal Reserve when it lost $4.6 billion in 4 months by making bad derivatives bets on currencies. The Federal Reserve had to bail out this fund or risk a banking crisis in the United States.
Derivatives were relatively new at the time. Today, they are rampant, and the risks of these instruments has never really been put to the test. One common type of derivative is called a “Credit Default Swap”. This is a fancy name for an insurance policy that pays out if someone fails to pay their debt. If we see a credit market implosion, it is likely the derivatives markets will experience an even larger implosion.
INFLATIONARY DEPRESSION OR DEFLATIONARY DEPRESSION?
I am not questioning IF the markets and the economy will crash as a result of all these risks. I am only questioning HOW the crash will unfold, and WHEN it will begin.
As for WHEN? Given that we are looking at the longest bull market in history, and looking at the chart it looks as though it has entered the euphoric phase, I suspect the crash will begin sooner than later. Perhaps beginning in the last quarter of 2018.
What about HOW? In the economic collapse of 1929, the United States was on a gold standard. This prevented excessive printing of money to save the economy, in spite of Roosevelt’s devaluation of the dollar in 1934. This inability to print money caused a deflationary spiral. With deflation, you wanted to own currency/cash, and not assets. Assets went down in price while currency held its value. If you just waited and held your cash, prices fell, and you could get more for that same money.
Since 1971, the United States has not been on the gold standard, allowing the government to freely print money any time the economy hiccups. They did it after the tech bubble. They did it after the 2008-2009 recession. My hunch is they will run with the same playbook again.
In an inflationary depression, you will want to own assets and not cash. With the government printing cash like crazy, cash becomes worthless and it takes more and more of it to buy the same things. This is what is happening in Venezuela, Argentina, and Turkey right now. Prices start skyrocketing and borrowing costs start skyrocketing. In Argentina, interest rates are roughly 45%, and in Turkey they are nearing 20%. Venezuela’s currency has become so worthless, borrowing it is almost meaningless. A milder version of such an inflationary depression is likely to happen here in the United States.
Now when interest rates rise, the interest payments on government debt, credit card debt, auto loans, and student loans will skyrocket. This will choke economic activity. If you have debt, you want loans with FIXED interest rates so you can pay back with cheaper dollars later.
BANKING SYSTEM FAILURES
There are roughly $15 trillion of fixed rate mortgages in the United States, about $5 trillion more than prior to the real estate crisis, with many earning the banks 5% interest. If all of a sudden, inflation were to start running at a 8% to 9% rate, the banks will begin losing about 4% in real value each year on those loans.
This loss of real capital, should this scenario pan out, will cause bank failures. As a result, having all your hard earned cash in bank accounts is not ideal.
WHAT TO DO
One can ride out an inflationary depression by converting cash to assets such as gold, silver, and perhaps even a cryptocurrency such as Bitcoin. As cash loses value, the price of these items will increase proportionately.
These times are unusual, and the risks are extraordinary. We have entered what looks like the final euphoric phase of the latest bull market, and when it crashes the extreme optimism will turn to fear and pessimism. History may not exactly repeat itself, but it always rhymes!