It is becoming increasingly clear that the “booming economy” touted by the Biden administration might not have been booming at all. In fact, quite the opposite may have been occurring, and now many investors across the board are being forced to acknowledge this reality.
In the article I published last August “FINANCIAL MARKETS REACHED A “SINGULARITY” NO ONE WANTS TO DEAL WITH,” I highlighted how GDP calculations were incredibly inflated, both directly and indirectly, by out-of-control government spending. Analysts failed to recognize this because they were still using outdated models and theories. This fueled market animal spirits that drove markets, especially US and European stocks, to historically high valuations completely disconnected from economic reality.
Now that Trump is intentionally curbing irrational government spending to rein in the US’s out-of-control government deficit (DONALD TRUMP IS PLAYING CHESS, NOT CHEQUERS), the struggle to find a new bullish narrative to keep feeding investors’ animal spirits and irrational exuberance is palpable. Reattaching stocks to the economy will be a painful process – in technical terms, this process is called “mean reversion”. Here’s how far we are from long-term means right now:
- If we exclude the brief spikes above 20 (quickly reined in by Central Banks and Government interventions), in the past 2 years the VIX average has been ~15 – a far cry from the VIX long-term average of ~19.5.
- The trailing P/E ratio for US stocks currently stands at ~28x compared to a long-term average of ~16x.
- The CAPE P/E ratio for US stocks currently stands at ~33 compared to a ~17 long-term average.
The recent correction barely impacted these metrics, which is why there is still a very long way to go before stocks return to levels fairly priced in relation to the underlying economy. Suppose you also consider that the underlying economy itself hasn’t really been booming in recent years. In that case, the expected correction will be even more pronounced since the real level stands much lower than what is reported by official (politically adjusted) public agency data.
Mean reversion is never a linear process, and markets always tend to overshoot the mean on the way down. To give you an idea, consider that the CAPE ratio stood at ~32 in 1929 right before the beginning of the Great Depression, and fell all the way down to ~7 in 1932. Applying the same calculations to today’s markets, US stocks are set to correct at least ~50% from current levels, but they won’t stop there. When investors panic sell in despair during the downfall, they will realistically drive this ratio all the way down to ~10-12 before it ultimately reverts to the ~17 long-term average. Yes, my dear reader, everyone should be prepared to see US stocks fall 70% from current levels. What about other countries? While prices are not as overvalued elsewhere as in the US, there is another powerful concept of Finance to always bear in mind: correlations. When investors start to panic, all correlations tend to converge to 1, meaning that markets outside the US will also suffer greatly in the future.
Will this be bullish for government bonds, as everyone traditionally “flies to safety” into highly rated ones? This will likely happen when panic is high, but nowadays governments are dealing with debt burdens far beyond those recorded prior to past market crises. Yes, they will bail out strategically important sectors of the economy once again, and Central Banks will be forced to monetize that additional debt because no major government has set aside surpluses in recent years. However, this time a bailout won’t be available to everyone, as that would ultimately impair the stability of the entire fiat currency system, with devastating consequences to economies far greater than the benefit of bailing out financial markets as a whole.
Assets with structural scarcity like gold will be the sure winners in all this mess because, even if prices might decline in fiat currency terms during the chaos and the need to liquidate anything that can fetch a bid, in the medium to long term they will inexorably rise, reflecting the monetary inflation required to bail out the strategic parts of the economic and financial system. All in all, the era of helicopter money is clearly coming to an end.
If you assume institutional investors aren’t making these exact same considerations, you are wrong. Price action already suggests there is a broad de-risking effort in the market to ensure portfolios can withstand the impact of an assured mean reversion process in the future. Personally, I don’t think Trump is willing to risk such a market catastrophe during his presidency, which is why he won’t push the envelope too much. However, many things are not under his control, and uncertainty is definitely rising in markets because people aren’t as stupid as their investment decisions in recent years would have suggested. They were just following the momentum not to be left behind, as I described in “WE HAVE NO ALTERNATIVE BUT TO RIDE STOCKS UNTIL THEY RUN”.
Is there any reliable indicator to keep an eye on to understand when things are going to turn seriously ugly? The answer is credit spreads, and as you can see in the chart below, we are currently far from a full-fledged financial crisis. But don’t get too comfortable, since these can spike suddenly and start running very fast when something in the delicate equilibrium of the global financial system breaks beyond repair.
JustDario on X | JustDario on Instagram | JustDario on YouTube