Inthe late summer of 1929, a well-known investor suddenly decided to sell all his stocks.
The markets were spiking, but after receiving stock tips from a young shoeshine boy, the investor decided to keep his money.
“If the shoeshine boy is giving stock advice,” he thought, “then it’s time to get out of the market.”
The investor realized the market had become too popular to do well, and thanks to that intuition, avoided the crisis.
While thousands of people were brought to their knees when the big crash happened, he kept his wealth intact. And when things got disastrous, he was able to buy several assets at rock bottom, increasing his wealth tenfold.
Today, almost a century later, as the echoes of 1929 grow louder, that investor’s behavior becomes, if not a model to follow, at least one to keep in mind.
For months now, several finance heavyweights have been suggesting a coming market correction.
High valuations, uncertainty about pandemic trends, and other weak statistics do not favor a rosy outlook.
Worse, a mix of excessive debt, near-zero interest rates, and wild speculation appears to be the prelude to economic disaster.
Back at the beginning of the year, Michael Burry, well known for predicting the 2008 subprime credit crash, repeatedly called the current one the “Greatest Speculative Bubble of All Time in all things.”
In a tweet, later removed, he wrote:
According to Jeremy Grantham, a legendary investor less known to the general public, the United States is in a bubble that typically occurs every several decades, comparable to the 1929 and 2000 bubbles.
Burry and Grantham are far from alone.
In a report, the European Securities and Markets Authority stated that the high debt, assets overvaluation, and growing speculation for high-risk investments could lead to a big crash in financial markets.
And according to the Economist Intelligence Unit, a sharp stock market adjustment is highly probable because of the current economic conditions.
About half of Wall Street strategists think the S&P 500 will already end the year below current levels. Bank of America predicts that this correction will be 10%, while Morgan Stanley, instead, 20%.
Among the most catastrophic, some warn of a 66% collapse, others 60% –in addition to potential negative returns for the next 12–15 years.
The S&P 500 fell 57% during the 2008 crisis, 49% in the dot-com bubble, and 34% during the COVID-19 crash. So if the most pessimistic predictions prove true, the next one would be the most dramatic crash since the Great Depression.
An alarm situation
Of course, such mammoth claims require a convincing argument, even if they come from someone with a proven track record of predicting market crashes.
And for sure, the first thing that sticks out is the market valuation. On November 8th, the S&P 500 reached its highest point, touching 4700 for the first time.
For months, large sectors of the market have been vastly overvalued. And the trend seems the same as in previous bubbles, with investors failing to see beyond trendy stocks, technology, innovation, housing, and little else.
Technology stocks turn out to be the most overvalued, with Tesla, Apple, Alphabet, Amazon, Microsoft, and Facebook (now Meta) making up 25% of the index.
On the crypto front, speculation appears even wilder. The market has surpassed 3 trillion in size, and some cryptos seem highly overvalued with market caps higher than some Fortune 500s, though not parallel adopted.
A new kind of investor
With an eye on the past, valuation is not the only warning indicator.
According to Jeremy Grantham, the most reliable sign of a bubble in its final stages is a hysterically speculative behavior –especially by individuals.
And to date, for the first time in this ten-year bullish market, the longest in history, speculation levels have reached record highs.
Since the pandemic began, a stream of new buyers has flooded the market.And investor sentiment has been fundamentally bullish since late March 2020, when the market hit its lows.
The momentum of commission-free trading apps has spurred the rise of retail investors: an amateur segment that invests small amounts of money from their wealth, but as a group can have a significant impact on the market.
In January 2021 alone, six million Americans installed a trading app. And in the first few months of the year, retail investors generated as much trading volume as mutual funds and hedge funds combined.
People are buying stocks and crypto with debt.
Another bad sign, given today’s market levels, is the amount of money borrowed to buy shares: the margin debt.
Basically, people rely on loans to bet on more securities than they could with their capital and maximize their returns.
However, this –in addition to being highly risky for investors in the first place– has often meant negative consequences for the stock market when its levels have risen significantly.
Currently, in tandem with the soaring stock market, margin debt has spiked.
Since the lows of March 2020, margin debt has grown 71% year over year. And from then to now, it has virtually doubled from $479 billion to $935 billion.
The last time margin debt grew at a similar rate was in 2000 and 2007, just before the dot-com bubble burst and the Great Recession.
Other indicators
A significant warning also comes from Schiller Price/Earnings Ratio, close to historical highs.
The indicator is approaching 40. And historically, with a value at 30 or higher, the S&P 500 has dropped between 20 and 89%.
Next, the gap between short-term versus long-term yields of Treasury bonds is narrowing. And this generally warns of a bearish outlook.
Should short-term yields become higher than long-term yields, then it would be a robust indicator of recession. An inversion, in fact, has been reliable in predicting every recession over the past five decades: the last seven times it happened, a recession occurred shortly after.
Third, Warren Buffett’s indicator, which measures the ratio of capitalization to GDP, is currently higher than it was between 1999 and 2000.
In the past, Buffett has said that the increase in the indicator is a significant warning sign of a future market crash. And he praised it as “probably the best single measure of where valuations are at any given time.”
Finally, the U.S. debt-to-GDP ratio has reached record levels. And high debt amounts in the past have been the hallmark of every financial crisis.
Inflation
Across most of the world, prices are rising at a rapid pace.
The consumer price index in the U.S. rose 5.4% year-over-year in September, and an alarming 6.2% in October, reaching the highest growth rate in 30 years.
A surge that Treasury Secretary Janet Yellen expects to remain elevated through the first half of 2022 –due to the effects of the pandemic that led to shortages in supply chains.
Historically, the effects of inflation on the stock market have not always been linear. However, what is troubling is how periods of high inflation have been linked to times of market instability.
The last two times inflation hit 5% and 6%, the United States were respectively in the midst of the 2008 financial crisis and at the doorstep of the early 1990s recession.
Fear for some, excitement for others
Predicting the exact moment when a bubble will burst is never easy. Grantham, for example, predicted the 2000 crisis well in advance, but it took almost three years for it to happen.
In 1997, he had sold his positions in U.S. equities, remaining for three years to watch as the market continued to rise. He lost half his portfolio, but in the end, he largely recouped his losses in the subsequent decline.
According to Wall Street, stocks may not experience a significant drop as long as the Fed pours monetary stimulus into the market.
Since March 2020, the central bank has purchased assets at a rate of $120 billion a month and imposed near-zero interest rates to stem the effects of the pandemic.
But starting this month, the Fed will begin to gradually reduce its investments by $15 billion a month until they reach zero in mid-2022.
Taking away this liquidity could trigger a bearish market. But even more likely will be the impact that rising interest rates will have on investor psychology.
Tightening interest rate policy will make equities less desirable due to reduced growth expectations, pushing investors towards more defensive investments. And this, together with the aspects already mentioned, could quietly cause a downturn in the stock market.
A downturn that someone awaits with excitement.
Indeed, no one knows better than seasoned investors that crashes are a great time to get wealthier and the place where great fortunes are made or lost.
Investors like Dan Pena, the founder of the investment consortium The Guthrie Group, are keeping much of their investable wealth in cash in anticipation of a correction and plan to invest it when the cataclysm breaks out.
Several financial and non-financial companies in the S&P 500 are preparing in the same way.
Only Apple, Alphabet, Microsoft, Amazon, and Facebook have $648 billion in liquidity combined, about a quarter of the total amount held by all S&P 500 companies.
And on the other side, Warren Buffett’s Berkshire Hathaway has amassed over $140 billion in liquidity, purchasing only three stocks in the second quarter.
Bottom line
While a force-nine market crash will be a catastrophe for most people, it will certainly be a fruitful opportunity for astute investors.
Since March 2020, wild speculation has flourished thanks to altered economic conditions, but it won’t end well for many people when the bubble bursts.
The higher valuations go, the more people should hoard money and be selective about stocks. They should move investments to under-allocated areas of the market or simply withdraw from bubbly ones.
Because otherwise, sooner or later, they will regret not getting out of them earlier.
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