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 We have described the vulnerability centred on US financial markets as like the precipitous avalanche-prone snowy slope. It just needed the final snowflake to bring it down. Trump and his lightweight camp followers are (probably) that final snowflake. The problem with avalanches is that they not only don’t reverse, but they gather momentum heading down.
There are three key elements fuelling that momentum:
- Bubble of historic proportions. US stock market at maximum valuation.
- Mania of historic proportions. Investors (US and beyond) invested to the maximum.
- Once in a lifetime global regime change. Politically, geopolitically, financially.
It’s not easy to keep up. I will start with some input from Ray Dalio on the last point, then consider downside risk based on a variety of calculations, and lastly how you might now respond, particularly if you find yourself with large cash weightings after applying your stop-losses.
HUGE CHANGE UNFOLDING
“The world is now shifting rapidly in fundamental ways that have never happened in our lifetimes, but have happened many times before” said Ray Dalio in his 2021 book, “The Changing World Order”. He set out a template for how events would unfold, leaning on an analysis of 2,000 years of major economic and geopolitical cycles, and it was spookily accurate as to how events are now unfolding.
He recently updated where we are:
“The big thing to keep in mind is that we are seeing a classic breakdown of the major monetary, political and geopolitical orders. This sort of breakdown occurs only about once in a lifetime, but they have happened many times in history when similar unsustainable conditions were in place”.
Ray is particularly concerned with mountains of debt:
“Holding debt late in the cycle, when there is a lot of debt outstanding, is risky relative to the interest rate being given. Holding debt is a bit like holding a ticking time bomb that rewards you while it is still ticking, and blows you up when it stops.”
Put another way, we are now late in that debt cycle and you are not being paid enough interest for the risks of holding bonds.
The recent selling is not just of bonds, but rather it has been a broadly based withdrawal from dollar assets - equities, bonds, and the dollar itself. The trust of global investors in the US has been lost, and could take years to rebuild.
Trust goes with confidence, and confidence amongst companies and consumers within the US has also fallen sharply. This is why the odds of a US recession are very high, though the scale remains uncertain. If Trump continues to lose his nerve, it could be relatively mild. In fact the relatively mild response in US financial markets to date is because major players believe that Chinese tariffs will be cut sharply, and most other tariffs will be negligible. Then the issue becomes whether Trump can perform this embarrassing volte face quick enough to limit the damage, because:
“The entirety of the US based asset system from stocks to US Treasuries and the dollar, are still at risk of a collapse in value”. (Ed Harrison, Bloomberg)
HOW FAR DOWN?
Valuations matter, and US equities have been overvalued for a long time, and remain more over-priced, on a number of measures, than the 1929 and 2000 extremes. The following numbers are compiled by Steve Blumenthal, and mostly sourced from Ned Davis Research.
Based on 61 years of corporate earnings history, if the S&P fell to the level of “Median Fair Value” based on the Price Earnings Ratio, it would be about 28% below where it is today (3,900). Bear in mind this is only “median”, whereas markets will typically overshoot as panic takes hold.
As Steve points out, if you buy at that level you should get a steady 10% per annum of growth, even though, in the shorter term, there might be lower lows as investors capitulate.
With a US recession the base case for many analysts, since 1946 the average fall accompanied by a recession was 35.8% versus 27.9% on average without a recession. Several have declined more than 50%.
The famous Shiller PE ratio, with data from 1850, shows that the S&P would have to fall 50% from its level of 10th April to reach the median valuation.
We have previously highlighted John Hussman’s number crunching. On his measures, the S&P would need to lose 73% just to restore a run of the mill valuation, one consistent with an expectation that you will subsequently achieve 10% per annum returns.
For Robert Prechter’s Elliott Wave team the issue is not valuations per se, but the story of the waves. There can never be certainty on this, but if the S&P 500 has now hit a major peak which will stay in place for years, history gives a good sense of the personality of the downtrend at different stages.
For example, in the first move down the investing public surges to the buy side, ignoring obvious cracks in the investing environment. They have certainly been doing that in recent weeks. The largest leveraged fund tracks the tech-heavy NASDAQ index, with 3x the return of the index, up or down. Two weeks ago, after it had fallen 63%, there was a $2.3 billion buying stampede from retail investors. The bottom will only be in place with the death of such euphoria.
BEEN HERE BEFORE?
“Investors abandoned their attention to valuations”. Not a recent perspective, but the insight of Benjamin Graham and David Dodd after the 89% fall following the 1929 peak. The results of such complacency were tragic for investors.
“Veteran traders look back at those months and wonder how they could have become so inoculated with the ‘new era’ views as to have been caught in the inevitable crash.” That from Robert Rhea in 1932 recounting the 1929 peak.
The complacency of investors today has a disquieting resemblance to investors sleep-walking into the 1929 Crash and its aftermath. The losses in 1929 certainly played their part in fuelling the Great Depression which followed, and the public participation today is far greater.
For example, US households have more in equities than they hold in real estate. This is rare, and indicates the volume of potential selling.
How these US investors react in coming months will have a big impact on the likelihood and depth of any US recession. Two thirds of US gross domestic product (GDP) is consumer spending Over half of that spending and all of the spending growth over the last two years has been driven by the top 20% of households by income, and these wealthy individuals have been happy to keep spending because the stock market has gone up so much.
Said another way, the US economy has become more financialised and thus more dependent on the rising stock market to buoy the mood of wealthy consumers.
As Orbis Investment Management put it “It’s easy to see how downward trends could feed on each other. A slumping market makes wealthy people rein in spending. That pullback weakens the economy, prompting fears of a recession. Those fears rattle investors, weighing on the stock market. Feeling less flush, consumers pull back some more and so on.”
WHAT SHOULD YOU DO?
What you should own and when you should buy (and sell) are the most difficult yet crucial questions in investing.
You can start with your immediate objective. What concerns you more. Missing 5-10% of upside or sidestepping 30-50% of downside?
If you have applied a stop-loss, you will now have substantial amounts in cash. We suggest a 30 day buy back, but it is sensible to finesse this for the prevailing circumstances. The 30 day buy-back worked well in a secular bull market stretching back 3-4 decades from 2020. We are now in a different place.
Think of the 30 day mark as a point for review. This is a list for consideration.
- Absolute Return
- China equities
- Germany/Europe equities
- UK equities
- Japan small caps
- Brazil equities
- Defence equities
- Agriculture
- Yen
- Euro
- Gold
The Absolute Return sector is undoubtedly a mixed bag. But you could select 3-5 funds which each have a different strategy and achieve genuine diversification. The UK becomes more interesting if it breaks up through 8700, at which point also look across to European equities and possibly Defence ETFs.
At any moment China might announce more reforms to boost domestic demand, with a sharp rise from equities. Consider dripping in ahead of that. Japanese smaller companies continue to outperform large caps, which are under pressure from a strengthening yen and trade turmoil. Again consider dripping in.
Brazil ploughs its own furrow. Drip if the Bovespa index goes up through 137,500. Agriculture is interesting. In a world of supply chain issues, climate shocks, and a growing population, it feels like it should have done better. Tuck away a small exposure?
We’re generally not keen on direct currency exposures, but if capital flight from the dollar persists, the euro and the yen are obvious beneficiaries.
There will also be a point to consider a diversified AI exposure, and more broadly based commodities, but it feels too early.
Since the peak for the S&P 500 on 19th February, gold has been THE investment to have held. On Tuesday it spiked to $3,503 intra-day, and this felt like a classic spike higher at the end of an uptrend, typical with commodities, but not with equities. Even if it is merely the beginning of a correction in an ongoing uptrend, support is 15-20% lower looking at iShares Physical Gold (IGLN). If I am wrong, the gold price will quickly turn around and up through $3,500
To stress, this is merely a list for consideration. Nonetheless, it is deliberately an eclectic list as the big risk today is positive correlation – all of your investments falling at the same time. The risks are plentiful, and banana skins abound.
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