THE UPCOMING BEAR MARKET

We got a lot of reactions to our recent post titled “SELL” and felt it was appropriate to delve deeper into what makes us believe that 2018 will see the top of the Equity Bull market that started in 2009 and why US equities in particular should enter a classical Bear market that will unfold over the next couple of years.

BUY LOW, SELL HIGH has always been a proven way to make money.
And we are definitely in the SELL HIGH configuration at the moment.

The French say “ Acheter au son du Canon et Vendre au son du Clairon” may also apply, meaning that one should buy when Fear is prevalent and sell when Greed is present everywhere we look.

No equity rally could better illustrate this say better than the 2009–2018. In March 2009, investors felt that it was the end of their world. That was the time to BUY. Today the US economic, financial, corporate, interest rates and tax environments could not be better. This is the time to SELL.

Surely, it could take another few months before the markets turn, but still, we we are at is Dangerous territory, and it may be best to be prudent and not to chase this rally at this stage and any unexpected event could send stocks into a tailspin as it happened in 1987.

We wrote a lot about liquidity and how, in our view, the recent advances of risky assets had a lot to do with exceptional monetary policies that have flooded the world with liquidity and induced asset inflation. We are of the view that the three main central banks of the world are way behind the curve and that 2018 will be the year where they will have to change tack and run after inflation.

As we have highlighted many times, US bond yields are trading at a critical technical juncture and a break up in bond yields could create havoc in bond markets and question entirely the valuation metrics that are currently applied to the US Stock market.

• Valuation

But what really deserves more analysis is Valuation, and we shall concentrate on the US equity market in particular, as this is where the excesses are the most pronounced.

The US stock market today is characterized by a seemingly unusual combination of very high valuations, following a period of strong earnings growth, and very low volatility. What do these ostensibly conflicting messages imply about the likelihood that the United States is headed toward a bear market?

To answer that question, it is worth looking at history and try to identify the patters that led to the bear markets of the past. A “classic” or “traditional” bear market as a 20% decline in stock prices.

There has been 13 bear markets in the US since 1871. The peak months before the bear markets occurred in 1892, 1895, 1902, 1906, 1916, 1929, 1934, 1937, 1946, 1961, 1987, 2000, and 2007. Within 12 months of these peaks, the US stock market fell by at least 20 %, sometimes in just one single day, the October 1987 crash, sometimes over a more protracted period of several months.

We had the privilege many years ago to meet Robert J. Shiller, a 2013 Nobel laureate in economics, who teaches Economics at Yale University and is the co-creator of the Case-Shiller Index of US house prices.

He was the one who attracted our attention to the topping out off US real estate in 2006 and enabled us to predict the financial crisis in 2007 and the demise of Bear Sterns. He is the author of Irrational Exuberance, the third edition of which was published in January 2015, and he developed an extremely important tool for valuing equity markets while smoothing the natural ebbs and flows of corporate earnings boom and bust cycles, the CAPE ratio, or Cyclically- Adjusted Price Earnings ratio.

The cyclically adjusted price-to-earnings (CAPE) ratio is found by dividing the real (inflation-adjusted) stock index by the average of ten years of earnings, with higher-than-average ratios implying lower-than-average returns.

It may not give a precise sense of timing, but the one thing that is sure is that every time the CAPE ratio went to an extreme, a subsequent Bear market followed.

Using the very useful tool developed by the German research and asset management company STAR CAPITAL AG, we pulled out the CAPE of the US SP500 in December 2017 using 10 years earnings, 3 years earnings and 2 year earnings.

As can be seen form the 10-year CAPE ratio chart below, the US CAPE bastion now stands at 34.1324 x, a level higher than the 1927 level and second only to the excesses of the .dotcom bubble in 2000.

Indeed, nothing prevents the ratio to keep rising and equal or even surpass the 44.02 record reached in December 1999, but one thing is sure is that US equities are much more expensive today than they have been in the past and trade at roughly twice their average valuation of the past 100 years.

What is even more worrying is the fact that the ratio is rising even as earnings are growing extremely fast.

Using the 3 Year CAPE ratio to get a better feel for short term moves, the ratio is now much close to its 2000 peak and there again the recent vertical acceleration in the gauge really tells the story of a market that is getting ahead of itself.

Surely a lot of benefits are to be expected from Donald Trump’s tax cuts, but funding a US$ 1.5 trillion of additional deficits will also weigh on interest rates, and that in turn, will weigh on earnings.

Putting the CAPE ratio acceleration in the context of higher interest rates, higher energy prices, and tight labor markets and higher labor costs means that whichever one looks at it, corporate earnings growth will probably peak in the first quarter of 2018, leaving very little room for additional valuation expansion.

Finally, the 2-Year CAPE ratio shows that we are now trading at valuation levels never heard of in the past century at 37.1 times and the only times the SP500 traded at such levels, in 2000 and in 2008, a major Bear market followed.

Moreover, the vertical acceleration of the past two years, years during which earnings growth has been spectacular, tells us that the market has really fully discounted any potential increases in earnings at the current levels and ir ripe for a correction.

Based on historical data, real S&P Composite stock earnings have grown 1.8% per year, on average, since 1881. In 2016, real earnings growth was 13.2%, well above the historical annual rate and even higher in 2017 at 17.8 %. But this high growth does not reduce the likelihood of a bear market, quite the contrary.

In fact, peak months before past bear markets also tended to show high real earnings growth: 13.3% per year, on average, for all 13 episodes. Moreover, at the market peak just before the biggest ever stock-market drop, in 1929–32, 12-month real earnings growth stood at 18.3%.

Another piece of ostensibly good news is that average stock-price volatility — measured by finding the standard deviation of monthly percentage changes in real stock prices for the preceding year — is an extremely low 1.2%. Between 1872 and 2017, volatility was nearly three times as high, at 3.5%.

Yet, again, this does not mean that a bear market isn’t approaching. In fact, stock-price volatility was lower than average in the year leading up to the peak month preceding the 13 previous US bear markets, though today’s level is lower than the 3.1% average for those periods.

At the peak month for the stock market before the 1929 crash, volatility was only 2.8%.

In sum, when using the CAPE ratio, the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets. This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off.

The Chart below illustrates how expensive the US stock market is when compared to the rest of the world using the CAPE ratio. In fact , it is the most expensive it has ever been in relative terms, trading 5 times more expensively than Russia, let alone the NEGATIVE CAPE ratio of Greece.

But there are also other valuation measures that should be taken in consideration, and a very fundamental one is the PRICE TO BOOK RATIO, i.e. the multiple at which the stock market values a company when compared to the actual accounting value of the company.

Unlike earnings, book values are not nearly as volatile and therefore they can give us a decent indicator of how the market is valuing company assets.

The US P/B ratio is now 3.5 times, a much higher level than its 30 year average off 2.4 times and only second to the excesses of the 2000 dotcom bubble at 5x.

In relative terms, it is more than three times the value of China ( 1x ) Russia (0.8x ) or Greece at ( 0.7 x ).

France, Japan, and Germany tade at between 1.5x and 2x, and the world average stands at 1.5x- after a significant 8 years rally.

In fact, there is NOT ONE country in the world trading as expensively as the USA with such high level of premium to the accounting value of its corporations.

The only other country in the world trading above 3x is India, which is also the reason why we have pulled out of India as well.

The table below computed by STAR CAPITAL AG summarizes the ratios of the World Cheapest stock markets and the one below the World Most Expensive, using a scoring system that takes into consideration CAPE, Price to earnings, Price to Cash Flow, Price to Book, Price to sales, and Relative §strength on 216 and 52 weeks periods.

The US is the fourth most expensive while China is the second cheapest.

• Liquidity

No equity market analysis would be complete without a liquidity and flow of funds analysis.

As we stated in our introductory statement, the one factor that makes our era very different form all other eras ( apart form the 1999–2000 era ) is the fact that since 2008, Central banks around the world have been flooding the economies with liquidity.

To contain the damages of the 2008 financial crisis, the FED, the BOJ and the ECB have brought interest rates into NEGATIVE TERRITORY and maintained them there for many years, and they bought massive quantities of long dated bonds on their balance sheet taking trillions of Dollars of bonds into negative Yield Territory.

In other words, they have completely skewed the interest rate structure of our economic environments, creating a situation where corporations and individuals could borrow unlimited amounts of money at almost zero-interest rates and even, particularly in the last two years, with NEGATIVE REAL RATES OF INTERESTS.

In doing so, they have provided a massive boost to corporate earnings and allowed once again corporate balance sheets to re-leverage drastically.

Never in the past anything like this ever happened — apart from the infamous Greenspan 2000 bug era with all the consequences we know in terms of the dotcom bubble -.

Equity markets are all about liquidity.

Liquidity is like the sea tide. it lifts equity valuations and it is this phenomenon that explains how the US stock market could reach such elevated levels of valuations.

But guess what ? This is about to end and the tide of liquidity is about to reverse its course.

In fact it has already started. The FED started raising rates in 2017 and it will accelerate its normalization efforts in 2018. It has already stopped buying bonds and will soon start selling some, and the US bond market is on the verge of a major crack as bond yields are challenging the 30 year secular downtrend these very days.

When liquidity dries up and interest rates shoot up, the party will be over. No stock market rises with less liquidity and the FED’s prudence in raising rates testifies of its fears of creating another shock through asset deflation.

• Technical Analysis

Finally, technical analysis. Well, this is where psychology comes into play.

Asset prices are determined by the balance of investors wanting to buys and investors wanting to sell at any particular time, and technical analysis is based on behavioral finance and reflects that balance of power at any point in time.

The US stock market is in WAVE 5 of the bull market that started in 2009 and time projections are such that the end is near. It could be tomorrow or in three months time, but by the month of April 2018, a major top will have been recorded and the US Stock market will start a new classical A-B-C bear market that could see its value fall by 40 % at least, if history is any guide over the next two years.

Two ingredients were missing until now.

A trend-ending vertical acceleration, we have had it since the beginning of 2018

Euphoria, the recent announcement by Merrill Lynch that they could see the bull market extending well into 2019 testifies of the fact that even the more cautious institutions are finally turning bullish. The ratio of bullishness amongst investors newsletter has never been that high and cash levels are at the lowest in the past 10 years.

Finally, using the Moving Averages Convergence Divergence measure, the US stock market has never been that overbought since 1973.

The way we see the upcoming bear market unfolding is :

. A Major TOP forming from now till April 2018
. The First Downwave ( A Wave ) taking place between May and October 2018
. A Bear market Rally taking place between October 2018 and March 2019 ( B wave)
. The Second down leg of the Bear Market after that

Considering the excesses of the current situation and the likelihood of an accident in the bond markets, we do not exclude another scenario, where by a very sudden crash takes place with a very sharp 20 to 25 % depreciation happening at anytime.

• Conclusions

All the characteristics of a SELL HIGH situation are present at the moment and extremes have never been so pronounced. Investors may or may not want to take notice, but anyone relying on factual analysis and privileging reality over hope should take a very cautionary stance.

This is a good time to stay in cash and bail-out of the US stock market. Surely, they may miss some gains left in the move, but indeed they will save a lot of money if one looks at it over a period of 12 months.

All the indicators are flashing RED :

CAPE RATIO Price to Book Earnings Liquidity Technicals

If you stay invested, at least you will have been warned !

Cover Photo by Matthias Goetzke on Unsplash

Originally published at Mechelany Advisors.