Why The Next Stock Market Crash Will Be Faster And Bigger Than Ever Before

Authored by Simon Black via SovereignMan.com,

US stock markets hit another all-time high on Friday.

The S&P 500 is nearing 2,600 and the Dow is over 23,300.

In fact, US stocks have only been more expensive two times since 1881.

According to Yale economist Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio – which is the market price divided by ten years’ average earnings – the S&P 500 is above 31. The last two times the market reached such a high valuation were just before the Great Depression in 1929 and the tech bubble in 1999-2000.

Some of the blame for high valuation goes to the so-called “FANG” stocks (Facebook, Amazon, Netflix and Google), whose average P/E is now around 130.

But there’s something different about today’s bull market...

Simply put, everything is going up at once.

Leading up to the tech bubble bursting, investors would dump defensive stocks (thereby pushing down their valuations) to buy high-flying tech stocks like Intel and Cisco – the result was a valuation dispersion.

The S&P cap-weighted index (which was influenced by the high valuations of the S&P’s most expensive tech stocks) traded at 30.6 times earnings. The equal-weighted S&P index (which, as the name implies, weights each constituent stock equally, regardless of size) traded at 20.7 times.

Today, despite sky-high FANG valuations, the S&P market-cap weighted and equal-weighted indexes both trade at around 22 times earnings.

Thanks to the trillions of dollars printed by the Federal Reserve (and the popularity of passive investing, which we’ll discuss in a moment), investors are buying everything.

In a recent report, investment bank Morgan Stanley wrote:

We say this not as hyperbole, but based on a quantitative perspective… Dispersions in valuations and growth rates are among the lowest in the last 40 years; stocks are at their most idiosyncratic since 2001.

So, ask yourself… With stocks trading at some of the highest levels in history, is now the time to be adding more equity risk?

Or, as billionaire hedge fund manager Seth Klarman notes… “When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

Volatility – as measured by the Volatility Index (VIX) – remains below 10 (close to its lowest levels in history). For comparison, the VIX hit 89.53 in October 2008, as the market plunged.

We haven’t seen a 3% down day since the election. And if that holds through the end of the year, it will be the longest streak in history.

And this false sense of security comes just as the main driver of this bull market – the trillions of dollars global central banks printed after the GFC – is coming to an end.

Markets saw around $500 billion of accommodation in 2016. And “quantitative tightening” should suck about $1 trillion out of the markets in 2018… That’s a $1.5 trillion swing in two years. And it’s a major headwind for today’s already overvalued markets.

But that’s just one issue. Remember, we also have…

Slowing global growth, record-high debt, potential nuclear war with North Korea, a rising world power in China, and cyber terrorism (just to name a few of the potential pitfalls) …

Still, investors continue to put money to work without a care in the world.

And more and more of that money is being invested with ZERO consideration of market valuation – thanks to the rise of passive investing.

Through July 2017, exchange-traded funds (ETFs) took in a record $391 billion – surpassing 2016’s record inflow of $390 billion.

According to Bank of America, 37% of the S&P 500 stocks are now managed passively.

Investors in these passive index funds and ETFs pay super-low fees in return for an automated investment process. For example, any money invested in a passively-managed S&P 500 ETF is equally distributed (based on market cap weighting) across the 500 S&P companies… So, companies like Apple, Google, Facebook and Amazon get the biggest share of that money.

The result… as this dumb money rushes in, the biggest stocks get even bigger – despite their already ludicrous valuations.

And the biggest players in this field are amassing a tremendous amount of power.

Vanguard, which introduced the world’s first passive index fund for individuals in 1976, has $4.7 trillion in assets (around $3 trillion of that is passive).

BlackRock, the world’s largest asset manager and owner of the iShares ETF franchise, is approaching $6 trillion in assets. And only 28% of BlackRock’s assets are actively managed.

Passive funds owned by these two firms are taking in $3.5 billion a day.

Bank of America estimates Vanguard owns 6.8% of the S&P 500 (and stakes of more than 10% in over 80 S&P 500 stocks).

And as long as the money keeps flowing into passive funds, the bubble keeps expanding.

At a time of exceptional market risk, more and more money is being managed without any notion of risk.

But what happens when these uninformed and value-agnostic investors have to sell?

Humans are emotional creatures. And when we do finally see that 3% (or even larger) down day, investors will rush for the exits.

And the computers will pile on the selling (every model based on historically low volatility will completely break when volatility spikes).

But when the wave of selling comes, who will be there to buy?

As these passive funds dump the largest stocks in the world, we’ll see an air pocket… nobody will be there to hit the bid.

And when the drop comes, it will come faster than anyone expects.

So, while most investors are ignoring risk, I’d advise you to use this record-high stock market to your advantage…

Sell some expensive stocks to raise cash. Own some gold. And allocate capital to sectors of the market that haven’t been blown out of proportion thanks to the popularity of passive investing. That means looking at smaller stocks and stocks outside the US.

Even if stocks go up for another year, which they may, it’s simply not worth the risk to chase them higher… Because the downturn will be devastating.

 

Comments

adolphz Mon, 10/23/2017 - 15:41 Permalink

Bigcrash coming, been coming the whole time since dow was at 7thou  SUCKERS  Shepwave nailed rally and aggressive sell signal  for NAZx today. 

tgatliff Mon, 10/23/2017 - 15:51 Permalink

When the wave of selling starts, Central Banks will step in and buy just as they have been doing for over 8 years now.   This is why volativity is so low.  People have been trained to step in on declines because they always know that CBs have their backs.   This will stop when central banks decide that it will stop.Everyone knows to BTFD now... The only way this stops is that all central banks must coordinate and allow a fall to occur.   With Trump in office and cheering stocks on, I do not see this occuring anytime soon.

Oldwood tgatliff Mon, 10/23/2017 - 17:05 Permalink

Can they actually stem the tide however if the purge becomes too great?There is no doubt in my mind that everyone knows what this is but still thinks they can time it out, and there is no doubt that our governments think they can control it, but it still depends on the size of the wave. We are already sustained by irrationality of the postive nature, but that does not revert to zero, it goes to equal proportions (or worse) of negative. Gov will shut the markets, stop the bleed but to do so for long attacks the very basic premise of our false confidence model that we have been hovering above the Grand Canyon on for years now. If they can prevent any large reversals I believe they will hold this forever...only its result will be a slow grind downward until all assets are in government's hands.

In reply to by tgatliff

In.Sip.ient Mon, 10/23/2017 - 15:53 Permalink

Sorry, but with CBs buying "assets", this marketis NOT GOING DOWN ( short of a nuclear strike )EVER! Simple as that! ON EDIT: 'Course, I've said nothing about the valueof those CB related currencies...     

nmewn alexcojones Mon, 10/23/2017 - 16:08 Permalink

"Now with rich soft corinthian leather!Yes my friends, when you want to treat yourself to a handcrafted, tax subsidized vehicle with new improved less flammable batteries and automatic acceleration into interstate guardrails combined with cockpit ejector seats...demand the new Tesla with rich soft corinthian leather as your car. Elon needs mo money." - in the voice of Ricardo Montalban ;-)https://www.youtube.com/watch?v=Vsg97bxuJnc

In reply to by alexcojones

wmbz Mon, 10/23/2017 - 16:03 Permalink

Nukes, EMP's no matter what the machine will keep this shit going!Next year DOW 30,000 hell it may be 35,000. Who knows, but crashing 10,000 points ain't gonna happen. Who in the Banksters Inc. cartel would allow that?

JoeTurner Mon, 10/23/2017 - 16:03 Permalink

I predict one day markets will be "shutdown until further notice"...the gubmint will announce due to unpredictable events and "russian hacking" the markets must remain closed until a full investigation can be done...There is simply no way the MIC can allow true price discovery to happen in these markets as the result would be a catastrophe of biblical proportions....

ByTheCross Mon, 10/23/2017 - 16:08 Permalink

If algos can simulate a random ascent punctuated by the odd blip, they can simulate a cliff drop.If you intend to buy at that bottom, you've missed the point.

sgorem Mon, 10/23/2017 - 16:12 Permalink

“The [private] Central Bank is an institution of the most deadly hostility existing against the principles and form of our constitution . . . . If the American people allow private banks to control the issuance of their currency . . ., the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered” (Thomas Jefferson, 3rd U.S. President).

WhackoWarner sgorem Mon, 10/23/2017 - 17:32 Permalink

private control over the issuing of a country's currency? Let's put this to a worldwide vote.  Working stiff has not one clue about how this works.  Nor how IMF loans (with %) have laid waste to developing nations and their assets.Clever bastards.  And the root of the problem.Recent court challenge in Canada from COMER tried to address this same issue. 

In reply to by sgorem

Stud Duck Mon, 10/23/2017 - 16:17 Permalink

The ISIS plan has blown up inour faces, the couple of $trillon of treasure on blood has been pissed away on Iraq and now Iran own Iraq with the Rushkies with Turkey leaning also. So with a little incident in the gulf, and the Russian pulling an embargo on oil, I predict a increase in the cost of gas to the US citizen to be close to $6 to $8 per gallon. This could happen before Christmas, then the whole thing slides down the shitter!

bardot63 Mon, 10/23/2017 - 16:43 Permalink

I alone, all by myself, control the entire market.  If I place $10,000 in an S&P fund tomorrow, the market will tank 60% by 10 a.m. Wednesday and will continue sliding for months until I've lost it all.  The history is clear on that.  My system never fails.  On the other hand, if I stay out, the market will continue to climb furiously.Currently I am pondering just what to do.