So, why should it be different this time, specifically in the third quarter of 2014 and forward? Okay, I don't profess to actually know that we have seen the peak and are now looking into the abyss of a 50 percent fall in average stock market values. However, here are five good reasons why that is actually the case:
- No real people left in the market; just 10% real trading means nothing holding us up
- It's all central banks and they are close to the end of the magic rope. Confident?
- Debt works until you can't pile more on top and the Ponzi scheme topples
- The bull has run farther than normal; the pendulum swings back when momentum fades
- Valuations are extreme but hidden in averages and behind debt tricks and deficits.
Let's go through the variables in more detail:
1. There are no real people left in the market. Since the peaks of 2000 and 2007, market turnover has fallen by more than half. At the same time algorithmic trading ("robots") has increased its share of trading from 10-20 per cent to 80 per cent. That means that "real" trading has fallen by 90 per cent! That is part of the explanation why the market has been so technical, so trending, so smooth on the surface, so easy to manipulate and so easy to "rescue" when needed during sudden bouts of weakness. The flip side is that there is no bottom, nothing to hold prices if and when the robots decide to get out or even to play the downside. Then 80% of the market will disappear or even start selling instead of buying.
2 It's all central bank magic and castles in the sky - without any mechanistic relationship between printing money and rising stock markets (or profits for that matter). Stocks are up because stocks are up. More money in deposits does not necessarily mean higher prices or profits. Sure, lower interest rates lead to more debt than otherwise, more created money to buy houses and also leaking into the stock market as a carry trade. That works as long as there is confidence in the system, but now the cracks are showing: unemployment may be down, but job market participation too and food stamp use has skyrocketed. Also see point nr 1; it has been easy to sell the narrative that money printing "works" and back it with manipulated markets where robots rule but the robots don't care which way they make money once the trend changes. And now the so called market internals (Dr Hussman's notion) have cracked.
3 Debt is all around. When houses stopped working as ATMs, car and student loans took over. Also, corporates have been borrowing (partly because they could, because rates were so low and (junk) paper demand so high, partly because they needed to buy back their own shares to support earnings per share and compensate for stock option dilution). And governments have not held back, gladly accepting 5-10 per cent deficits per year. All that debt will have to be paid back eventually, or defaulted upon. Zero sum game? No, not so much, since the other man's wealth that was founded on being paid back will disappear and with that both his and the borrower's wealth and demand evaporate. In addition margin debt on the NYSE is higher than ever. Yes, ever. Yes, compared to the market cap.
4 The bull is very long in the tooth. The bull market has outrun itself. For one, it has gone on for very long and the upturn has been historic (+200% on the S&P in 5.5 years). Second, every lever has been cranked to maximum for decades. All variables that formed the base for the rally since [take your pick: 1945, 1982, 2009] have gone from supportive to being liabilities: population growth, productivity, leverage (debt), global growth, environmentalism, government deficits, individual savings ratio and more. The market is at least due for an ordinary correction of 10-20%. Those usually come along once a year and now it's been years since the last one. And when that happens, trend followers may get signals to sell, pushing markets down another 10%. And by then value players in the form of hibernated bears may bet on market levers to normalize, thus looking for another 10% down, which in turn leads to stop losses, margin calls and redemptions (remember the margin debt on NYSE that is used to buy shares by leveraging your existing holdings), forcing some planned long-only accounts to sell - and there you have another ten per cent down. By then, the downturn takes on a life of its own, making everything undershoot at the same time, just as has happened so many times before; the more euphoric the peak, the more dystopian the trough. Imagine simultenous generational lows in debt, profits, valuation multiples, turnover etc,
Me, partying like it's 1999 (which it was)
5 Valuations are at their highest ever - this variable should be nr 1 on the list, given how extreme it is. However, valuations usually work as a stopped clock, or like the sun to a comet. Follow the trend as long as it is stable, but when the comet starts to turn (market internals weaken), remember it won't just slow down, it's coming all the way back to the sun... and then some. Valuations tend to be reasonable for a very short time around 2-3 times per full cycle, as the market swoops by at high speed between its extreme highs and lows. They can however guide you to when you can start buying during the downturn - even if prices probably will fall much further, giving you plenty of opportunities to average down a couple of times (often more times than you would like)
Easy to get euphoric at the peak
(me in my underwear at 7km; 23 000 feet)
it is due because the trend is broken
In summary, the most important reason this rout may last, and may rival the downtuns of 2002 and 2008, is simply that it is overdue. It is overdue for a lot of reasons: Time, Increase, Debt, Valuations, but most of all it is due because the trend is broken.
the dynamic has changed
That means the dynamic has changed from one where central banks and robot traders are perceived to be in control, and where buyers are buying because others are buying, because that is what you are supposed to do (think all the newbies in the market, that have only seen markets trending upward; the buy the dip newbies), to a situation where confidence in the system, in central banks and in the buying of others is eroding.
Stopping the bull (again)