Executive Summary
The first and easiest leg of the bursting of the bubble we called for a year ago is complete. The most speculative growth stocks that led the market on the way up have been crushed, and a large chunk of the total losses across markets that we expected to see a year ago have already occurred. Given the starting conditions of extraordinary speculative euphoria, this was all but certain. The negative surprises of last year, from war in Ukraine to the global inflation spike, were quite unnecessary to ensure a significant downturn.
Now things get more complicated. While the most extreme froth has been wiped off the market, valuations are still nowhere near their long-term averages. Further, in the past, they have usually overcorrected to below trend as fundamentals deteriorated. Such an outcome still remains highly likely, but given the complexities of an ever-changing world, investors should have far less certainty about the timing and extent of the next leg down from here. In fact, a variety of factors – especially the underrecognized and powerful Presidential Cycle, but also including subsiding inflation, the ongoing strength of the labor market, and the reopening of the Chinese economy – speak for the possibility of a pause or delay in the bear market. How significantly corporate fundamentals deteriorate will mean everything during the next twelve to eighteen months.
Beyond the near term, for long-horizon fundamental investors, the biggest picture remains that long-run issues of declining population, raw materials shortages, and rising damage from climate change are beginning to bite hard into growth prospects. The resource and geopolitical shocks of last year will only exacerbate those issues. And over the next few years, given the change in the interest rate environment, the possibility of a downturn in global property markets poses frightening risks to the economy.
The State of the Bubble: Things Get More Complicated
Well that was exciting! There have been far too many boring years in my 55-year career and 2022 was not one of them! Right up front we can all agree on one thing: stocks, whether blue chip or speculative, are a whole lot cheaper than they were a year ago and buying them now will give a much less disappointing return than would have been the case then.
So let’s review the bidding. The S&P 500 needs a rally of 33% to recover last year’s losses in real (inflation-adjusted) terms, 1 the Nasdaq an intimidating 61%, and ARKK, Cathie Wood’s ETF, as a proxy for aggressive growth stocks, would need to triple! Some of the very largest cap and most reliable growth names – the likes of Amazon, Alphabet, and Meta, the wonder companies of the past decade – have to rise 70% to 150% to regain their 2021 peaks. And the damage in a single year to broadly diversified stock/bond portfolios is the worst in nearly a century. At the beginning of last year, in “Let the Wild Rumpus Begin,” we predicted that total losses across the three major asset classes of stocks, bonds, and real estate could reach $35 trillion in the U.S. alone, including $17 trillion in stocks and $6 trillion in bonds. Well, so far, with real estate still making up its mind, losses in U.S. stocks have been over $10 trillion and in bonds over $5 trillion, in addition to an unexpectedly large loss of $2 trillion in cryptocurrency. Certainly, a decent chunk of the losses we predicted have already occurred, a down payment if you will.
Year-end reviews are generally ascribing these pretty serious losses to the combination of the war for Ukraine, described as unexpected, and the surge in inflation, also described as unexpected in its severity and persistence. (A few commentators also throw in Covid-19 and the unexpected bottlenecks and reduced growth Covid caused in the global economy, especially in China.) The key here is of course the word “unexpected.” The irony for me is that I expected just this kind of broad market decline without any such unexpected help. My reasoning was simple. Explosions of investor confidence in persistently rising prices, such as existed two years ago, are rare and have only occurred in the U.S. three times in the equity market – 1929, 1972, and 2000 (and even then, 1972 was marginal) – and a single time in the housing market, in 2006. In the equity market examples, in order to reach bubble proportions, the three all needed long economic upswings, record or at least handsome margins, a strong employment situation, and behavior from the Fed and the government that was supportive of speculation. In short, a nearly perfect environment for investors. From these economic, financial, and psychological peaks there was probably only one way things could proceed: they could only deteriorate, and that is precisely what they all did.
The interesting feature of these incremental “unexpected” mishaps of the last year is that they are likely to intensify and complicate the last phase of our current market downturn. As my last note “Entering the Superbubble’s Final Act” tried to make clear, the first phase of an extreme bubble breaking is in my opinion almost certain – and rightly or wrongly that was how I saw the 2000 and 2007 breaks in their first phases. To prick these bubbles all you have to do is have investors question whether their nearly perfect economic and financial conditions can indeed be extrapolated forever. 2
Almost any pin can prick such supreme confidence and cause the first quick and severe decline. They are just accidents waiting to happen, the very opposite of unexpected. But after a few spectacular bear market rallies we are now approaching the far less reliable and more complicated final phase. At this stage housing markets, which are always slower to react, have not fully rolled over yet; neither has the economy gone into recession, nor have corporate profits yet been severely hit. The length and depth of continued market decline from here depends on how precisely the deterioration from perfect conditions will play out.
War in Ukraine is not straightforward to say the least. Ukraine, Russia, and Belarus play big roles in grain and oilseed and even bigger and more dangerous roles in fertilizer. The unsettling of geopolitics that the invasion caused and the near impossibility of calculating the follow-on effect of limiting Europe’s energy – not to mention risks resulting from the price and availability of food and energy in some vulnerable developing countries – all contribute to a rare level of uncertainty. Some of these uncertainties might resolve into pleasant surprises and so there might be an unexpected (for bears at least) muddling through to recovery. But on the pessimistic side, many of us might agree that seldom have so many severely negative potentials been out and about. “Polycrisis” may well be the word of the year. Should any one of these factors get out of control it might cause a severe global recession.
One important factor is that the bursting of the global housing bubble, which is only just beginning, is likely to have a more painful economic knock-on effect than the decline in equities is having, for extreme bubble pricing in stocks has been confined to the U.S. only. Other equity markets vary from fair price to normal or moderate overpricing. In real estate, by contrast, even though 2021’s near 20% gain in U.S. house prices – the largest annual gain in the record books – left the house price multiple of family income in the U.S. (now 6x, up from 4.5x in 2011, according to Census Bureau data) above its previous record in 2006 at the height of the housing bubble, that ratio is still way below the 10x to 20x multiples in cities from Vancouver, London, and Paris to Shanghai, Sydney, and Taiwan.
Housing busts seem to take two or three times longer than for equities – from 2006 for example it took 6 years in the U.S. to reach a low – and housing is more directly plugged into the economy than equities through construction starts and associated expenditures. Housing is also much more important for the middle class, whose wealth is often mainly in housing, who use far greater leverage through established, traditional mortgages than they ever do in stocks, and who are these days sitting on large gains resulting from 40 years of falling mortgage rates pushing up housing prices. Many of them see their houses as a major store of value and the bedrock of their retirement plans, and to see that value start to melt away will make them very nervous. (Mortgage costs expand to fit the available affordability. Thus, as interest rates fall you take bigger mortgages because you can and as the mortgages grow in size house prices rise too.) So don’t mess with housing! But we have. And real estate markets that had come to be thought of as impregnable, Australia and Canada for example, have finally started to decline, with Canada down a shocking 13% last year. Other overpriced markets on mainly variable rates are very likely to follow.
The long list of things that have gone wrong – that could interact and cause some component of the system to break under stress (perhaps an unexpected component) – makes for depressing reading. The complexities have multiplied, and the range of outcomes is much greater, perhaps even unprecedented in my experience. That having been said, the odds of a major U.S. market decline from here cannot be as high as they were last year. The pricking of the supreme overconfidence bubble is behind us, and stocks are now cheaper. But because of the sheer length of the list of important negatives, I believe continued economic and financial problems are likely. I believe they could easily turn out to be unexpectedly dire. I believe therefore that a continued market decline of at least substantial proportions, while not the near certainty it was a year ago, is much more likely than not.
My calculations of trendline value of the S&P 500, adjusted upwards for trendline growth and for expected inflation, is about 3200 by the end of 2023. I believe it is likely (3 to 1) to reach that trend and spend at least some time below it this year or next. Not the end of the world but compared to the Goldilocks pattern of the last 20 years, pretty brutal. And several other strategists now have similar numbers. To spell it out, 3200 would be a decline of just 16.7% for 2023 and with 4% inflation assumed for the year would total a 20% real decline for 2023 – or 40% real from the beginning of 2022. A modest overrun past 3200 would take this entire decline to, say, 45% to 50%, a little less bad than the usual decline of 50% or more from previous similarly extreme levels.
But this is just my guess of the most likely outcome. The real risk from here is in the unusually wide range of possibilities around this central point. I would suggest wide and asymmetric error bars around any such forecast. Regrettably there are more downside potentials than upside. In the worst case, if something does break and the world falls into a severe recession, the market could fall a stomach-turning 50% from here. At best there is likely to be at least a further modest decline, which by no means balances the risks. Even the direst case of a 50% decline from here would leave us at just under 2000 on the S&P, or about 37% cheap. To put this in perspective, it would still be a far smaller percent deviation from trendline value than the overpricing we had at the end of 2021 of over 70%. So you shouldn’t be tempted to think it absolutely cannot happen. (For an example of a real nightmare, in 1974 the S&P troughed at below 7 times earnings!)
Now for timing. There are some complicating factors that seem quite likely to drag this bear market out. Let’s start with that irritating factor, the Presidential Cycle, so simple sounding that no one in the fee charging business can afford to be associated with it. And that is presumably why it continues to work. The important fact here – see Exhibit 1 – is that for 7 months of the Presidential Cycle, from October 1st of the second year (this cycle, 2022) through April 30th of the third year (2023), the returns, since 1932, equal those of the remaining 41 months of the cycle! This has a less than one-in-a-million probability of occurring by chance, pretty remarkably, and it has been about as powerful in the last 45 years as the previous 45 years. We are now in this sweet spot, which once again is up nicely so far. The logic and nuances are spelled out in Appendix 1. Suffice it to say that this positive influence may help to support the market for a few more months.
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