50% Correction Is Impossible! Really?

Tyler Durden's picture

Submitted by Lance Roberts via RealInvestmentAdvice.com,

There is little doubt currently that complacency reigns in the financial markets. Nowhere is that complacency more evident than in the Market Greed/Fear Index which combines the 4-measures of investor sentiment (AAII, INVI, MarketVane, & NAAIM) with the inverse Volatility Index.

The reason I revisit the index above is due to last Thursday’s “3-Things” post in which I presented two arguments concerning the potential for a 50-70% decline in the markets. John Hussman’s view was simply a valuation argument stating:

“To offer some idea of the precipice the market has reached, the median price/revenue ratio of individual S&P 500 component stocks now stands just over 2.45, easily the highest level in history. The longer-term norm for the S&P 500 price/revenue ratio is less than 1.0. Even a retreat to 1.3, which we’ve observed at many points even in recent cycles, would take the stock market to nearly half of present levels.”

The second argument was from Harry Dent based on demographic trends within the economy as the mass wave of “baby boomers” become net-distributors from the financial markets (most importantly draining underfunded pension funds) in the future. To wit:

At heart, I’m a cycle guy. Demographics just happens to be the most important cycle in this modern era since the middle class only formed recently — its only been since World War 2 that the everyday person mattered so much; because now they have $50,000-$60,000 in income and can buy homes over 30 years and borrow a lot of money. This was not the case before the Great Depression and World War 2.

 

And based on demographics, we predicted that the U.S. Baby Boom wouldn’t peak until 2007, and then our economy will weaken — as both did in 2008. We’ve lived off of QE every since.”

Not surprisingly, those two comments drew a lot of fire from readers such as this one:

Or this one…

Hmmm….where have I heard this before.

“Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted. I expect to see the stock market a good deal higher within a few months.”

 

– Dr. Irving Fisher, Economist at Yale University 1929

This Utopian belief of now infinite stability within the financial markets due to ongoing Central Bank interventions is a most dangerous concept.  This is particularly the case given the structural and economic shifts in the economy due to the rise in debt which has derailed the efficient allocation of capital. As shown below the economy is currently mired at the lowest average annual growth rate since 1790. (Data courtesy of Measuring Worth)

Furthermore, a quick analysis of past history suggests the regularity of corrections which have run the gamut of devastating blows to investor capital. (Monthly data courtesy of Dr. Robert Shiller)

If you look at the chart above you will notice the longest economic expansions in history have also been followed by declines of 30% or more. With the current economic expansion now the 3rd longest in history at 92-months, a subsequent correction of 30% or more should not be surprising.

Of course, what fuels corrections is not just a change in investor sentiment, but an ignition of the leverage that exists through the extension of debt. Currently, leverage is near the highest levels on record which is the equivalent of a tank of gasoline waiting on a match.

And…corporate leverage. The chart below shows the total liabilities and equity of non-financial businesses in the U.S. divided by the Gross Value Added. I have overlaid the S&P 500 for relevance.

As can be clearly seen, leverage fuels both halves of the full market cycle. On the way up, increases in leverage provide the capital necessary for accelerated share buybacks and increased speculation in the markets. Leverage, like gasoline, is inert until a catalyst is applied. It is the unwinding of that leverage that accelerates the liquidation of assets in the markets causes prices to plunge faster and further than most can possibly imagine.

It has only happened twice already since the turn of the century. Yet, less than a decade from the last crash, investors have once again fallen prey to excessive exuberance and the belief that somehow this time will most assuredly be different. 

Measuring The Size Of The Next Correction

As a portfolio strategist, there is little question the markets are still confined to a bullish uptrend. Currently, portfolio allocation models remain near fully invested. Therefore, what concerns me most is NOT what could cause the markets rise, as I am already invested, but what could lead to a sharp decline that would negatively impact investment capital.

[Important Note: It is worth remembering that winning the long-term investment game has more to do with avoidance of losses than the capturing of gains. It is a function of math.]

What causes the next correction of magnitude is unknown. It always is until after the fact. There are many factors that can, and will, contribute to the eventual correction which will “feed” on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The chart below shows the deviation from the long-term trend line. I have calculated an advance to 2400 for the S&P 500 which, as I published in “2400 or Bust”, is a reasonable target for the current “melt-up” phase of the market.

As stated above, the bull market trend which began in 2009 remains currently intact (dashed blue line). A correction from 2400 back to that bullish uptrend line, which occurred in both 2011 and 2012, would entail a decline to 2100.  That would be a 14.2% decline and while not technically a “bear” market, for many investors it will certainly “feel” like one.

But what if a simple correction accelerates? To analyze how a market accelerates to a 50% correction, we can use a “Fibonacci Retracement” analysis as shown in the chart below. As defined by Investopedia:

“The Fibonacci retracement is the potential retracement of a financial asset’s original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.”

So, a 50% retracement from the 2400 level would push the markets back towards 1547. As identified in the chart, a 23.6% retracement from the 2009 lows would violate the bullish trend line. Such a violation would set up a change in trend, from bullish to bearish, thereby bringing more selling into the market.

If the next wave of selling starts to trigger “margin calls,” the next three levels of retracement become much more viable. The market would initially seek out support at the 38.2% retracement level of 1748 which would be a decline of 27.16% and would push the markets into an “official” bear market. As margin calls accelerate, so does the forced liquidation which then bleeds over into psychological panic selling as investors reach the point of capitulation.

This is where “buy and hold” quickly becomes “get me the $*@# out.”

That can’t happen you say? As shown in the chart below, corrections of 50% to 61.8% of the previous advance are common with corrections even eclipsing 100% as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already 91-months into the current cycle and extremely levered, there is a rising level of risk that should not be ignored.

By the way, a 50% retracement would register a 35.5% decline in investor portfolios. A 61.8% retracement would destroy 43.9% of investor capital.

And that is how you get a 50% decline.  

However, while I show that the greater levels of a potential correction will likely be coincident with a recession, as they have historically been, it does NOT mean that a recession is required. A sharp rise in interest rates or inflation, a downturn in economic growth, deflationary pressures from the Eurozone, or a credit related issue in the “junk bond” market could all do the trick.

No one will know, until in hindsight, what the catalyst will be that ignites a “panic” in the market. This is why we do analysis to understand the potential risks in the market as compared to expected reward. What is abundantly clear is that the potential “upside” in the market is currently outweighed by the “downside” risk. It is important to remember that our job as investors is to “sell high” and “buy low.”

Unfortunately, for most, they are already doing exactly the opposite.

There is one important truth that is indisputable, irrefutable, and absolutely undeniable: “mean reversions” are the only constant in the financial markets over time. The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years.

Don’t think it can happen?

You might want to reconsider.

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carlnpa's picture

Please help me get an idea to those who can do something with it.

McConnel say Congress will not pay for these. Then we must.

Lets start crowd funding for a couple things if congress won't pay for it.

1) Investigation into voter fraud

2) Investigation into H1B fraud

Trump - Go directly to the people in these two areas NOW, we will directly pay for it.  

Just ask us.

venturen's picture

First step break up the mega banks....as they have too much power and make them compete instead of just buying Washington!

froze25's picture

"This time it's different". All the dude wanted was his rug back.

NoDebt's picture

TPTB know the score.  The next "crash" will be the widowmaker.  They'll do anything to prevent that.

 

The Saint's picture
The Saint (not verified) NoDebt Feb 6, 2017 10:58 AM

Thanks for the BULLISH charts.  BTD

auricle's picture

"I expect to see the stock market a good deal higher within a few months"

Dr. Stanley Fischer, Economist Massachusetts Institute of Technology 2017

Countrybunkererd's picture

selling for 10x earnings...ok.  selling for 25x's earnings...ok.  selling for 45x's earnings...ok.  Why not 250x's earnings or 1000x's?  inflation and all that will catch up eventually, or is that term hyperinflation...ummm.  As you can see, leading economists with a Dr. in front of them are never wrong.  This will go on until the PPT can't keep it going anymore, somewhere about that time when the world walks away.

SoDamnMad's picture

It's going to be from the black swan. LISTEN to Nassim Taleb.

Someone else is going bust. Either Italy, or China or Japan and then everyone in Wall Street will head for the door at once. Then margin calls and sell orders to make the margin calls all building on top of one another like a giant wave.  

armageddon addahere's picture

It's not a black swan if you see it coming.

Fundies's picture

I see a black swan with a headlight coming.

BlueHorseShoeLovesDT's picture

GS in the White House cranking up the money machine again.

venturen's picture

Obama made the USA into Illinios...a BASKET CASE

BandGap's picture

I could give a shit if they dropped 95%. Seriously. Pull the fucking pin.

Ban KKiller's picture

So....all in! Bullish as corrupt accounting will "fix" everything!

Yen Cross's picture

 It's imminent+++  Bitchez

BlueHorseShoeLovesDT's picture

Nice Vix smash to get the "market"going.

 

 

They run it between 10 and 13 to goose the "market" these days

buzzsaw99's picture

thanx 4 the bug lulz

lester1's picture

You idiot doom and gloomers simply don't get it. We don't have crashes anymore due to the Federal Reserve and Central Banks always stepping in.

 

Do some research on the plunge protection team, and exchange stabilization fund. They are parts of national security.

 

Until you understand this, you will remain clueless!!

BigFatUglyBubble's picture

Unless they take out their winnings (stolen booty) and let it crash on purpose.  Things are not as they appear.  There are many layers to the "truth onion." 

Even if there is not a crash the currency will be made into toilet paper.  The doom and the gloom is there because the economy is not real: it's all bad speculation and distorted values.  China, NK, Iran, Russia, see US as weak and they will not be pushed around any longer.

froze25's picture

Totally get that but the Plunge protection team has been there since the early 80's and crashes have happened. So they will happen again, It's just a matter of when the PPT decides either not to step in or they aren't able to stop it.

Secret Weapon's picture

They will crash it and cash in once DJT is perceived as having ownership of the economy and not before.  9 months from assuming office.

adr's picture

By 2025 all but the absolute youngest baby boomers will have entered retirement, most of the younger boomers are actually poorer than Gen X and have no holdings.

This mass of boomers will need to spend every dime they have to pay for medical care and the asinine prices of everything inflating 20% a year.

Who exactly are they going to sell their stocks, bonds, and real estate to? Millennials?

The only buyer will be the Fed and when the Fed owns all financial assets, the market is over. In fact the market IS over and the only buyer of any consequence is central banks.

That means there is no flow of capital to the true economy. Also by 2025 White America becomes a minority. When that happens there will no longer be enough tax revenue to cover the EBT class, let alone the rest of .Gov.

It won;t matter if stocks correct 50% or go up 300%. Stocks and the Stock Market become meaningless. Crashes also happen to go straight up, Like Wiemar, Zimbabwe, and Venezuela.

EINSILVERGUY's picture

Nice. I turn 62 in 2025 and would cash my first SS check. So I got that going for me

mkucstars's picture

So it's different this time. Yeah, got it, loud and clear. Nobody saw it coming, didn't think it was possible, isn't that what they always say?

Lizardking's picture

Will not drop more than 15% and will probably go up 15% more from here before it drops 15%. Why? The Fed is still running down easy street. Money will not flow out of this market until fed signals a real change in policy going forward. Every sell off will be followed by new highs so keep portfolios with a bullish majority.

Gradual increase in rates, below one percent still and look at where we are with economy/jobs. My area is growing leaps and bounds, money everywhere and real estate hotter than ever. Rates should be at 3%. Until we get close to that number stay long the stock market. If you're looking to enter wait for a spike in the Vix index.

adr's picture

What area is growing by leaps and bounds? waiters at Applebees? H1B tech "workers"?

Don't confuse gambling with real economic growth. Housing bubbles do nothing but destroy capital.

The past eight years have been the worst period for real economic activity since the dawn of time. Even during the Great Depression more real business flourished.

Lizardking's picture

Montana, real estate up 35% over three years, what you could once rent for $500 now costs $1500, new businesses, hotels and buildings going up monthly. Ski resorts seeing increase in ticket sales +30%, airports more crowded than ever, roads more crowded than ever, Yellowstone tourism highest ever, there's just a lot of money flowing around here and it's not all debt fueled. Everywhere I travel I see the same thing as I see here in Montana. Rates should not be below 1%, the fact that they are considering growth and expansion I see means Fed wants to keep the good times going. You want to fight that be my guest but now is not the time to be a prepper or a bear. It won't end well and your powder will be dried up when the real correction occurs.

Farmer Joe in Brooklyn's picture

I live in MT also...sounds like same area (Bozeman)...

The problem is that it can all turn on a dime. The massive debt can and will act as an accelerate when the tide turns. Either massive deflation in assets, massive inflation (already seeing, as you mentioned), or I believe most likely...an implosion in assets followed by nuclear QE ("crackup boom" type theory).

Regardless, prepping and diversifying are absolutely essential. Anything but is foolish.

Inzidious's picture

Kinda hard to argue with this

ajkreider's picture

Well a  50% correction would mean a forward p/e of 8 something.  That's not happening unless there is a major recession.

nakki's picture

What's so hard to figure out CB'S print money to buy assets, that they then own. The banks that own the CB'S eventually will own everything. 

Bailouts shift private debt to the public. In the US war on everything is paid for through public debt. Sure it creates jobs but in reality its welfare for the few. Crony capitalism has been taken to a higher level. Corporations have gone fully fraudulent thanks to low rates and NON GAAP. Buy up shares with debt and the few can cash out. If eventually their shares get whacked why should they care, they've already cashed out. Think about the fact that people that perpetrated the first "financial crisis" where the same people that reaped the rewards for the fraud they committed.

Everyone who works in the financial industry has become redundant thanks to the counterfeiters at the CB'S. When you can "print" at will and fraud has become the norm, everything else is mental masturbation. In the end if corporations pile up debt and the "market" corrects 60-70% they'll bailout the banks that own the debt all over again to "save" the "free market".

Centralized Confiscation and Consolidation through Counterfeiting. 

EndOfDayExit's picture

+100

Going forward the market will only correct if CBs decide it is somehow in their benefit or if the balance of political power changes in a major way (and CBs get a tap on the shoulder). Absent any of that, CBs went full retard and there is no going back.

This said, I am not participating with my own money as I have no idea when CBs may decide to change their mind.

Farmer Joe in Brooklyn's picture

Well said....

And the other elephant in the room is the pension ponzi. ZIRP for 8 years has chased these formerly risk-averse investors (along with insurance companies) way out on the risk curve. Many, if not all, have increased their equity allocations by double-digits (10-20% or more!!) just to try to keep up with their obligations. Who in their right mind thought it was wise or prudent to keep 7-8% targeted returns in this rate environment..??

The fact of the matter is that they KNEW they couldn't make those returns (without vastly increasing risk)...but it was political and/or career suicide to admit as much. So they chased yield into the darkest corners of the market. That's all fine and good until the market cracks...then bombs away!!

If you think pensions are woefully underfunded now, wait until you see what happens with a 50% equity correction. Hint: 30% equity allocation cut in half = 15% of total funds go "poof"

This is why @nakki is 100% correct...NOTHING will happen until the CB's are ready to pull the plug. Could be days, months, or years...we plebes won't know until it happens.

yogibear's picture

Gartman says no.

Ben A Drill's picture

As long as EBT cards get refilled every month, no food or water shortages the FED will always say things are great. Brokers will always say buy the dip... Don't miss out of the next rally. Just look at financing a new car. 60 to 96 months. What could go wrong?

Jack.Lincoln's picture

nothing meaningful is ever said in red font

aesthetic bullying is indicative of a weak person

Bear's picture

I use red a lot but mainly to record my profits after all I am The Bear

swampmanlives's picture

Hindsight is 20/20

swampmanlives's picture

Automation and robots will prop up earnings since businesses can lay off just about everybody.

NoWayJose's picture

Any such move is magnified by the Fed already using up its bullets, and the shear magnitude of debt. Neither of these things has been as strongly negative in any prior crash!

BlueHorseShoeLovesDT's picture

When you think about going short just look at the picture of Trump signing the EO on Dodd-Frank, focus on Cohn.

 

Candy Store, Kid

logicalman's picture

Cohn is only a threat to the unconnected.

He's left the Squid to advise Trump, but It's a good bet that that is only 180º for the revolving door.

Back to GS having set things up in their favour, with all the bonuses that will follow.

 

charms's picture

I dare you ... I double dare you.

DOGGONE's picture

Look at the inflation-adjusted Dow:
http://showrealhist.com
How far is down?

Don Sunset's picture

A 50% drop in the Dow and more in the NAZ is a sure thing in my book. The question is which GOVTs won't survive the next big slam down 

Looking forward to watching the EU disintegration  

ali-ali-al-qomfri's picture

'we've lived off QE ever since.'

Quantitative Eating,

it too, won't last.