Bubbleville is deflating: Why things are about to get much worse
The S&P 500 is hovering above bear market territory and history suggests stocks may have farther to fall.
Put down your phone. Pause your streaming service. Close your eyes and listen. Really listen. You can hear it faintly in the background. At first it will sound like nothing. But slowly you’ll start to hear to faint hiss of Bubbleville deflating. The S&P 500 is hovering above bear market territory and history suggests stocks may have farther to fall.
Years from now it will be described differently. The bubble analogy naturally lends itself to a more dramatic conclusion. The scribes will describe the bubble as “popping” or “bursting”. But that not what it will feel like to live through it.
The citizens of Bubbleville will not go gently into the night. Buy the dip, they plead on Twitter. Shares are on sale, they implore. They believe that if they simply manifest that shares are cheap, it will be true. Bravado is the order of the day.
What’s teetering on the precipice of collapse is not just the share market, but a great illusion. The illusion that it’s all so easy. That we are one chat board tip from riches. One index fund from independence.
I have no idea where markets will go from here. But at times of stress, I try to rationally examine the present. Zoom out, they say, so that it what I’ll do.
This means more than looking at a long-term chart of the market. It involves gaining true perspective on what is happening. As I write this, the S&P 500 is within striking distance of a bear market, down close to 18% year to date. The tech heavy NASDAQ is down more than 28% while the ASX 200 clocks in at a relatively mild 8.5% loss this year. Small cap growth shares, crypto, SPACs and the rest of the speculative legion – don’t ask.
In Bubbleville, the collective memory starts around April of 2020. This event feels unprecedented but that is far from the truth. This is the thirty-seventh time the S&P 500 has corrected since 1950 – or one correction every other year. More than a quarter of the time that correction turned into a bear market when share prices fall more than 20%. History suggests that we have more correcting to do.
Presented with facts, Bubbleville will likely concede the events of the last few months are precedented. But are their calls to ‘buy the dip’ the logical reaction? If share prices have fallen, aren’t they on sale? Shouldn’t we double down?
From heroes to villains
Central banks have left the party. The ethos of Bernanke’s ‘helicopter money’ has been replaced with the damn the recessionary torpedos mentality of Volker. Institutional investors have left the party pulling $199 billion out of the market this year, JP Morgan data shows. But retail investors party on with $114 billion of inflows into the US market through March, according to Goldman Sachs.
Oscar Wilde reportedly called a cynic a person that “knows the price of everything and the value of nothing.” I may be taking a cynical approach to Bubbleville, but in this case, I will lead the calls to consider value. The end of Bubbleville will mean a return to fundamentals but there is no reason to not start now.
Instead of penny jar wisdom, it’s time for truth. Far from being on sale, the market is expensive. Historically when you invest in expensive markets, you achieve lower future returns. Speculative excess may last longer than some people expect. It may last longer than it has any right to. But it will end.
Zooming out means we want to avoid the messiness of the day-to-day market movements but also the quarter by quarter and half year by half year fluctuations in earnings. A write-off here, an asset sale there. The cyclicality of the economy. We will therefore consider the CAPE ratio -the cyclically adjusted price to earnings ratio. We look at the average earnings over the past 10 years and adjust those earnings for inflation. It is about as zoomed out as you can get. We started the year with a CAPE ratio of just under 40 on the S&P 500. It has fallen to around 31 this year. That is still high. Since the year 2000 the average monthly CAPE ratio of the S&P 500 has been 27. That means we would need the market to drop roughly 13% to get back to average given current 10-year earnings.
If we zoom out even more to the start of the twentieth century, the average monthly CAPE ratio is a little more than 17 over the last 120 years. In fact, the only time that the CAPE ratio has been as high as it was at the beginning of the year was right before the dotcom bubble burst where it topped out at 44 in December of 1999. In our last extended bear market during the GFC, the market bottomed out with a CAPE ratio of around 13. It isn’t going out on a limb to say the market has further to fall.
History would suggest that the last gasp of Bubbleville will not be kind to the retail investors that bought at the top and are now deviating from their plans to “buy the dip”. The similarities between our current predicament and the dot-com bubble and subsequent crash are eerie. We recorded a podcast on it in April last year which has aged rather well. The speculative excess we’ve seen in crypto, NFTs, SPACs and technology shares were mirrored during the internet craze of the late ‘90s.
In 1999, the Federal Reserve started raising interest rates and continued into 2000. The market peaked in March of that year. Yet throughout 2000 when the NASDAQ fell just under 40% and the S&P 500 went down 9%, retail investors “bought the dip”. They ploughed $388 billion into US shares as internet company insiders and institutional investors were selling. As losses continued, retail investors abandoned the market in droves and the rout was on. The Nasdaq fell 21% in 2001 and 31.5% in 2002. The S&P 500 followed suit with a drop of 13% in 2001 and 23% in 2002. Huge losses in the share market impacted the overall economy and the Federal Reserve started cutting interest rates again in 2001.
No fuel in the tank
The one major difference between the dot-com crash and today is the flexibility of central banks to respond. In 1999, the Fed Funds rate was 5.5% and inflation was running at a reasonable 2.2%. Quantitative easing was not even on the radar. Today, interest rates are at record-lows, inflation is at 40-year highs and central bank have swollen balance sheets after years of asset purchases.
Investors have gotten used to central banks stepping in to bail them out. These days, the best that is hoped for is that record levels of consumer, government and corporate debt will put a de facto cap on interest rates. Anything can of course happen, but I’m willing to bet that central banks will happily increase stress on consumers and potentially drive the economy into a recession if it means stopping runaway inflation. Inflation has too much of a history of toppling governments to let it get out of control.
This may be a difficult environment to navigate as investors. We’re entering an inflection point from one investing era to another. The silver lining is that the end of Bubbleville may usher in a return to rationality where fundamentals once again matter. This will be a cathartic event as many investors will face more losses and many people will give up on investing all together. Sadly, many of the people giving up will be new investors who are entering their prime earnings years where cheaper valuation levels can lead to lifetimes of strong returns.
In the fifth, and I suspect final, trip to Bubbleville I will cover what investors can do to try and get through the messy end of a bubble.